Academic journal article IUP Journal of Applied Finance

The Impact of Derivative Trading on the Liquidity Beta of Underlying Stocks in India

Academic journal article IUP Journal of Applied Finance

The Impact of Derivative Trading on the Liquidity Beta of Underlying Stocks in India

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Asset pricing theories generally treat liquidity risk as an unsystematic risk and hence assume that it has no impact on asset pricing when an investor creates a diversified portfolio of assets. Till recently, little attention was given to it in academics. A seminal paper by Amihud and Mendelson (1986) established the fact that liquidity of stock plays a role in asset pricing. Market for real estate demonstrates the deep impact of liquidity on asset prices. Though the prices are dependent on the supply and demand, there is no forum where buyer and seller can communicate. This information asymmetry absorbs liquidity from the market. The real estate agents earn high commissions for providing liquidity. Their commissions are high because of the lack of forum where such assets can be sold. But with the advent of Internet, the commissions have significantly gone down as it has become comparatively easier for buyer and seller to locate each other.

Amihud and Mendelson (1986), in their seminal paper, studied the impact of liquidity on return on assets. They find a significant positive relationship between the returns and illiquidity where assets with lower liquidity in equilibrium yield higher returns. After establishing the role of liquidity in asset pricing, academic literature took another leap forward when Chordia et al. (2000) found the existence of market-wide liquidity and also that the liquidity of all stocks move together. Chordia et al. (2000) divided the liquidity into two parts: day-to-day liquidity that seems to be reasonably priced by the market participants, and dynamic liquidity which is the function of the market conditions. Pastor and Stambaugh (2003) studied the effect of liquidity fluctuation on the asset return. They argued that innovation in liquidity also impacts the asset return. Pastor and Stambaugh (2003) measured the impact of aggregate liquidity changes on stock returns through a new measure called liquidity beta. This part of liquidity risk is systematic and non-diversifiable in nature and thus has an impact on all securities in the market. Earlier studies on asset pricing by Conrad (1989) and Skinner (1989) found that derivative trading has no significant impact on the non-diversifiable risk of the stock.

Derivatives are not independent financial instruments and hence any trading in derivatives affects the underlying security in more than one way, beneficial and destabilizing, depending on numerous factors. Various studies have researched the impact of derivatives on volatility, price, trading volume and liquidity of securities. According to Ross (1976), derivatives improve the opportunity set for the investors and hence increase the efficiency of the market. Investors with a high risk assessment sell the stock and buy the derivative, and investors with a low risk assessment buy more of the stock and sell the derivative of the stock. The net effect is to increase the aggregate demand for the stocks and thus derivative complements the stock. The stock is more valuable in the presence of its derivatives and its price increase. Conrad (1989) shows that the introduction of traded derivatives causes a permanent increase in the price of the underlying security beginning a few days before the start of trading.

Derivative trading was introduced in India in June 2000. Index futures contract in the BSE Sensex and the S&P CNX Nifty were launched first. Index options and individual stock options were introduced in June 2001 and July 2001, respectively. November 2001 saw the launch of single stock futures. Ever since the futures and options segment started growing in volume, the average daily turnover has increased from 101.07 bn in 2004-05 to 723.92 bn in 2009-10.

Several studies have examined the impact of derivative trading on volatility, liquidity and returns (Powers, 1970; Cox, 1976; Ross, 1976; Danthine, 1978; Chatrath et al. …

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