Academic journal article Indian Journal of Economics and Business

The Effect of Derivative Trading on Volatility of Underlying Stocks: Evidence from the NSE

Academic journal article Indian Journal of Economics and Business

The Effect of Derivative Trading on Volatility of Underlying Stocks: Evidence from the NSE

Article excerpt

Abstract

The present study empirically investigates the effect of futures trading on volatility in Nifty as well as individual stocks by employing both symmetric and asymmetric GARCH models. The Daily closing price of Nifty index and twenty seven individual stocks are also collected from January 1, 1997 to February 28, 2008. The results of GARCH reveal that spot market volatility has declined after introduction of futures trading. In case of individual stocks, there has been a reduction in volatility of the individual stocks with the exception of seven stocks namely, ABB, CIPLA, ITC, ICICI, INFOSYS, RANBAXY and SIEMENS. Further, the introduction of futures trading has altered the asymmetric response behavior of spot price volatility as well as individual stock volatility. The study finally concludes that the introduction of the derivative contracts have improved the market efficiency and reduced the asymmetric information.

Keywords: GARCH, GJR GARCH, Futures Trading and leverage Effects

1. INTRODUCTION

It is an issue of interest as to how introduction of futures trading affects volatility of underlying stocks, have made the issue interesting for both exchanges and regulators. Introduction of futures trading might increase spot market volatility due to low transaction cost and high degree of leverage in futures market. The speculators in derivative market attempt to influence the spot index underlying futures contract, through excessive buying or selling of the underlying index constituents, the volatility of these stocks could increase. The excessive volatility in stock market significantly affects on risk-averse investor, corporate capital investment decisions, leverage decisions and consumption patterns .Therefore, it is important to study the impact of futures trading on individual stocks volatility which has considerable interest for regulator.

The introduction of derivatives trading has received considerable attention. It has led to controversy over the effect of futures trading on volatility underlying assets. Some studies supported the argument that introduction of futures trading stabilizes spot market by decreasing its volatility. This is due to migration of speculative traders from spot to futures market. Futures' trading is expected to improve market efficiency and reduce informational asymmetries. The studies by Baldauf and Samtoni (1991) using the S&P 500 index in US, Darram (2000) using the FITSE Mid 250 contract in UK, Bologna (2002) using MIB 30 in Italy, and Raju and Kardnde (2003) using NSE 50 in India, support this view. They have shown a decline in the spot market volatility upon introduction of futures trading.

There are also studies which have supported that introduction of futures trading increased spot market volatility thereby destabilizing the market, as futures market promotes speculation and high degree of leverage. Harris (1989), Lee and Ohk (1992), have supported the destabilizing hypothesis. Thus, several of studies on introduction of futures trading on stock market volatility have been inconclusive. In the light of this background, the present study seeks to empirically investigate whether introduction of futures trading decreases or increases stock market volatility.

2. THE REVIEW OF LITERATURE

Pok and poshakwale (2004) examine the impact of the introduction of futures trading on spot market volatility using data from both the underlying and non-underlying stocks in the emerging Malaysian stock market. They employed GARCH to capture time varying volatility and volatility clustering phenomenon present in data. Their results show that the onset of futures trading increases spot market volatility and the flow of information to the spot market. Finally, the result shows that that the underlying stocks respond more too recent news, while the non-underlying stocks respond to more old news.

Golaka C Nath (2003) investigates behavior of stock Market volatility after introduction of derivatives by employing GARCH model. …

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