Impact of Derivative Market on Stock Market Volatility

Topics: Futures contract, Derivatives, Stock market Pages: 30 (9589 words) Published: February 15, 2013

AAMJAF, Vol. 4, No. 2, 43–65, 2008

Department of Business Administration, Mangalore University, Mangalagangotri – 574199, Mangalore, DK, Karnataka, India 2 School of Management and Business Studies, Mahatma Gandhi University, P.D. Hills, Kottayam – 686560, Kerala State, India *Corresponding author: 1

This paper studies the volatility implications of the introduction of derivatives on stock market volatility in India using the S&P CNX Nifty Index as a benchmark. To account for non-constant error variance in the return series, a GARCH model is fitted by incorporating futures and options dummy variables in the conditional variance equation. We find clustering and persistence of volatility before and after derivatives, while listing seems to have no stabilisation or destabilisation effects on market volatility. The postderivatives period shows that the sensitivity of the index returns to market returns and any day-of-the-week effects have disappeared. That is, the nature of the volatility patterns has altered during the post-derivatives period. Keywords: conditional volatility, heteroscedasticity, volatility clustering, market efficiency

INTRODUCTION The modelling of asset returns volatility continues to be one of the key areas of financial research as it provides substantial information on the risk patterns involved in investment and transaction processes. A number of works have been undertaken in this area. Given the fact that stock markets normally exhibit high levels of price volatility, which lead to unpredictable outcomes, it is important to examine the dynamics of volatility. With the introduction of derivatives in the equity markets in the late nineties in the major world markets, the volatility behaviour of the stock market has become further complicated as derivatives open new avenues for hedging and speculation. The derivatives market was launched mainly with the twin objectives to transfer risk and to increase liquidity, 43

T. Mallikarjunappa and Afsal E. M.

thereby ensuring better market efficiency. The examination of how far these objectives have materialised is important both theoretically and practically. In India, trading in derivatives started in June 2000 with the launch of futures contracts in the BSE Sensex and the S&P CNX Nifty Index on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE), respectively. Options trading commenced in June 2001 in the Indian market. Since then, the futures and options (F&O) segment has been growing continuously in terms of new products, contracts, traded volume and value. At present, the NSE has established itself as the market leader in this segment in India, with more than 99.5 percent market share (NSE Fact Book, 2006, p. 85). The F&O segment of the NSE outperformed the cash market segment with an average daily turnover of Rs291.91 billion, as compared to Rs114.79 billion in the cash segment from 2006 to 2007 (Derivatives Updates on NSE website,, 2007). This shows the importance of derivatives in the capital market sector of the economy. Previous studies on the volatility effects of derivatives listing provide mixed results, suggesting case-based biases. In addition, in India, there is a lack of robust examination of the impact of derivatives on market volatility. In India, trading in derivatives contracts has existed for the last six years, which is an adequate time period to evaluate its major pros and cons. Against this backdrop, it is important to empirically examine the impact of derivatives on the stock market. In this paper, we attempt to study the volatility implications of the introduction of derivatives on the cash market. Through this study, we seek evidence regarding whether the listing of futures and...

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