Academic journal article IUP Journal of Applied Finance

Empirical Relationship between Index Futures Prices, Volume and Open Interest: Evidence from Indian Futures Market

Academic journal article IUP Journal of Applied Finance

Empirical Relationship between Index Futures Prices, Volume and Open Interest: Evidence from Indian Futures Market

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Stock price movements, along with volume and liquidity, play an important role in formulating investment decisions. With the introduction of the financial derivatives in the Indian stock market, the investor has access to more sophisticated instruments to base their investment decisions. The Indian financial markets have a long history of operation, but the financial derivatives market was developed in the late 1990s. Derivatives trading started in India in June 2000 after Securities and Exchange Board of India (SEBI) granted the final approval on the recommendation of L C Gupta Committee. In 1998, J R Varma Committee worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulations) Act (SC(R) A) of 1956 was amended so that derivatives could be declared 'securities'. Futures trading is available on the index as well as some of the individual stocks. National Stock Exchange (NSE) accounts for over 95% of derivatives trading in India.

Presently, financial derivatives (futures and options) turnover overshadows the cash market turnover by almost five times on a trading day. This shows the importance of the derivatives market in the Indian financial market. It thus makes it even more important to analyze the various relationships that may exist among some of the more relevant variables in the Indian derivatives market. Such a study would help various market players in understanding the Indian derivatives market better. We have thus decided to analyze the relationship that may exist between Returns Volatility (RV), Open Interest (OI) and Volume (VOL).

Volume and open interest are secondary technical indicators in the futures market. Open interest is an important parameter in the futures markets; it is the number of contracts outstanding at any point of time. As a new contract is introduced, the investors start taking a view on the market of the underlying asset and take an exposure on the futures contract. However, open interest is different from volume. Volume refers to the number of contracts traded in a day. Cumulatively, it would always increase. Open interest would increase by the number of new contracts opened in a day. The contracts that are offsetting the initial position do not add to the open interest, but they do add to the volume. Volume indicates intensity of trade taking place or simply market activity, while open interest indicates depth or liquidity of the market. Open interest phenomenon is unique to the futures market. Since volume and open interest are considered secondary indicators in technical analysis to study the changes in price trends and predict reversals, it becomes imperative to understand if both volume and open interest have explanatory powers to be used as exogenous regressors in the conditional volatility equation to model the price fluctuations or volatility in the index futures returns series. Further, following Bessembinder and Seguin (1993), both trading volume and open interest are split into their expected and unexpected components. The expected component indicates the average level of trading, while the unexpected component indicates any surge in trading due to unexpected price changes. An increase in volume and open interest would thus indicate an increase in liquidity and improvement in price discovery with the possibility of lessening the impact of volatility.

Modeling and forecasting stock market volatility has been the subject of vast empirical and theoretical investigation over the past decade or so by academicians and practitioners alike. Arguably, volatility is one of the important concepts in the realm of finance (Brooks, 2002). It will not be prudent to establish a relationship between current period's volatility to its previous period's volatility alone, as it might give an incomplete and anomalous picture. Such a relationship may not be enough to explain the changes in the return series. …

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