Sunday, March 18, 2012

Effect of derivative trading on volatility of underlying stocks

The effect of derivative trading on volatility of underlying stocks: evidence from the NSE.

Chart of VIX - Volatility

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. 

There has been a debate about how introduction of index futures trading influence cash market volatility. The moot question has been whether introduction of futures trading stabilizes or destabilizes stock market volatility. The results 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 twenty individual stocks with the exception of ABB, CIPLA, ITC, ICICI, INFOSYS, RANBAXY and SIEMENS. Further, introduction of futures trading has altered the asymmetric response behavior both of spot price volatility as well individual stock volatility. Overall, introduction of futures markets improves the quality of information flowing to spot markets, and spot prices accordingly reflect more promptly changes that occur in demand and supply conditions. The finally results show that futures trading has significant role in reducing volatility of the S&P CNX Nifty, but market wide factors do not help to reduce the market volatility.

I think it is pretty clear to most of us by now that indeed, volatility has increased with the growth of derivatives trading.  

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