Academic journal article IUP Journal of Applied Economics

The Impact of Derivatives Listing on the Indian Stock Market

Academic journal article IUP Journal of Applied Economics

The Impact of Derivatives Listing on the Indian Stock Market

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Derivative instruments like futures and options are extremely versatile securities that can be used in many different ways. Traders can use these instruments to speculate, while hedgers can use them to reduce the risk of holding an asset and arbitragers can exploit the mispricing in the markets. The presence of these instruments allows investors to explore strategies which are otherwise not possible and make markets more efficient.

The effect of derivative introduction on the underlying securities has been widely studied in financial literature. According to Black and Scholes (1973), options listing should have no effect on stock returns as option prices are not a function of stock returns, whereas empirical evidence shows both positive and negative price effect due to option listings. According to Hakansson (1982), Detemple (1990) and Detemple and Selden (1991), introduction of option contracts has positive price impact, while negative price effect has been reported by Miller (1977) and Danielsen and Sorescu (2001). As theory provides no indication of the direction or magnitude of option listing effects, empirical research has gained momentum in this area.

The theoretical ambiguity of option listing effects also demanded extensive empirical research. Empirical evidence in the US is mixed, positive price effects until 1981 and negative afterwards. Studies from Europe and other developed countries have tilted more towards positive price effects, except in the case of the Netherlands where Kabir (2000) reports negative price effects on stock returns. The initial literature focused on options listing as individual stock options were introduced first in the developed markets and individual stock futures were introduced much later after the options on stocks were introduced. However, in India both options and futures were introduced relatively at the same time and this provides an opportunity to study the impact of derivative listings on Indian capital markets. Initial study on India by Chaturvedula and Kamaih (2008) has shown significant positive abnormal returns in the Indian capital markets. However, the Indian capital markets have undergone important structural changes wherein the volume of derivatives trading increased manifold in the years following 2008 and 2009, and in this context the present paper studies the impact of derivative listing on stock prices.

This motivates us to study option and stock futures listing effects on stock returns in a growing and emerging market like India, where derivatives trading grew 374 times in the the financial year 2013-14.

Moreover, it would be very useful to find out what effect derivatives listing would have on stock returns in India, an open electronic limit order book market where options and futures are listed simultaneously.

Derivatives Market in India

The derivatives trading in India started at National Stock Exchange (NSE) on June 12, 2000 when index futures on S&P CNX Nifty was launched. It was followed by the launch of index options and stock options and stock futures in the year 2001. Since its launch in 2001, the total trading volume in derivatives segment has seen an exponential growth. Total as well as the trading volume for each segment in the derivatives market. In the initial years until 2007-08, stock and index futures were very popular relative to index and stock options. In the year 2007-08, stock and index futures contributed more than 86% of total trading volume. However, by the year 2013-14, the total trading volume of stock and index futures dropped to 21% and equity index options contributed around 72%, with the stock options contributing the remaining 7%.

Literature Review

Options are modeled as redundant securities by Black and Scholes (1973). An option is called a redundant security because it can be synthetically replicated by a combination of assets already available in the market. …

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