Derivative products like futures and options in Indian stock market have become important instruments of price discovery, portfolio diversification and risk hedging in recent times. This research study is an effort to study the impact of introduction of index futures on the stock market volatility. In order to capture the impact of introduction of index on the volatility of the underlying, a dummy variable which takes up the value zero in the pre-introduction of index futures and one in the post-introduction is included while specifying the volatility dynamics. The results indicate that there is an indication of short-term volatility reduction but in the long run there is no significant impact on the volatility of the stock market.
Keywords: Derivatives, dummy variable, index futures, stock market, volatility Introduction
A derivative is a financial instrument whose value is derived from another underlying asset. The underlying asset can be foreign exchange, commodity price, interest rate, index of prices, equity or any other asset. The price of the derivative is driven by the spot price of the asset, which is the underlying. The derivative future contracts are exchange traded instruments where one party agrees to purchase an asset at future time for certain price and other party agrees to sell the asset at same time for same price. In India index futures were introduced in June 2000 and one year down the line in June 2001 index options were also introduced. Volatility of financial returns is best understood as the variability of the asset price and is estimated by the variance of the time series of prices. Volatility in any financial market is induced by changes in investor’s perceptions due to flow of new information to the relevant market at different points of time. Over a period of time, derivative products like futures and options have become important instruments of price discovery, risk hedging and portfolio diversification in stock markets all over the world. These flexible instruments enable traders and investors to assume a highly leveraged position at low transaction cost. In the Indian context derivatives were introduced as a risk management tool to reduce risk, transaction costs and volatility in the financial markets. According to Thenmozhi (2002) the introduction of derivatives products has significantly altered the movement of share prices in the spot market. The spot and the futures prices are linked by the arbitrage i,e, participants liquidating position in one market and taking comparable positions at better prices in another market, or choosing to acquire positions in the market with the most favourable prices. This raises important questions concerning the effect that the index futures have on the stock market volatility. This topic has been the focus of attention for investors, regulators, traders and academicians. Many theories have been advanced in this direction. The traditional views emphasizes on the Destabilization hypothesis i,e, by encouraging speculation derivatives gives rise to price instability and hence increase spot market volatility. The modern view argues that by frequent transmission of information and its rapid processing it reduces stock market volatility and thus, derivatives’ trading is fully consistent with the efficient functioning of the markets. The introduction of index futures in India has not been very old but the volume in case of derivatives market particularly in National Stock Exchange (NSE) has shown a tremendous increase and presently the turnover is even greater than the spot market. In 2010 it had surpassed Chicago Board Options exchange and Brazil’s BM&F Bovespa SA to become the fifth largest exchange while in 2009 its rank was seventh.
Ever since the introduction of index futures in the Indian adding markets there have been a lot of studies that...