INTRODUCTION OF DERIVATIVES AND ITS IMPACT ON INDIAN STOCK MARKET- A STUDY ON BSE & NSE

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1 INTRODUCTION OF DERIVATIVES AND ITS IMPACT ON INDIAN STOCK MARKET- A STUDY ON BSE & NSE Krunal K Bhuva Assistant Professor JVIMS-MBA, JAMNAGAR [email protected] Navjyot D Raval Assistant Professor JVIMS-MBA, JAMNAGAR [email protected] ABSTRACT Derivative products like futures and options on Indian stock markets have become important instruments of price invention, portfolio diversification and risk hedging in recent times. This paper studies the impact of introduction of index futures on spot market volatility on both S&P CNX Nifty and BSE Sensex. Surrogate indices like BSE 100 and Nifty Junior are introduced to evaluate whether the introduction of index futures per se has been instrumental in reducing the spot market volatility or the volatility has fallen in line with general fall in market wide volatility. Time duration for the study 1997 to 2005 has been selected. To find sensitivity beta has been calculated and to check the relationship between BSE-30 & NIFTY- 50 with surrogate indices. The results revealed that mean return of NSE increase by % in NIFTY-50 and for NIFTY Jr. its 49.72% which shows there is high level of volatility in the indices during the study period. Similarly for BSE & BSE 100 mean return increase by % & % respectively. Overall, average beta was found to be 0.84 and 0.73 for BSE & NIFTY respectively. Keywords: BETA, BSE, Correlation, Derivatives, Futures, NSE 1. 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, 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 per cent 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 Rs billion, as 166 Centre for Financial Services Gujarat Technological University CCFS2014

2 compared to Rs billion in the cash segment from 2006 to 2007 (Derivatives Updates on NSE website, ). 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 options lead to any significant change in the volatility of the cash market in India. In contrast to a sectorial index studied in previous research from Mallikarjunappa and Afsal (2007), we select a general index called the S&P CNX Nifty Index to which the first derivatives contract was introduced by the NSE in India. The previous study noted the peculiar characteristics of IT stocks and arrived at the conclusion that stock-specific characteristics must be studied for any general conclusion. As a benchmark index, the Nifty Index is expected to show wider, more balanced and more applicable results and thus can be treated as a true replica of the Indian derivatives market. Most of the Indian studies, such as Thenmozhi (2002), Sibani and Uma (2007) and Mallikarjunappa and Afsal (2007), did not consider options contract, but this study examines the introduction of options while also analysing volatility. The period under analysis spans from October 1995 through June Furthermore, to allow for a non-constant error variance in the return series, we applied a GARCH model that was more appropriate to describe the data collected. Therefore, the present work offers a valuable addition to the existing literature and should prove to be useful to investors as well as regulators, as this is a broader index than the one studied by Mallikarjunappa and Afsal (2007). The remainder of this paper is organised as follows. Recent literature is briefly reviewed in Part 2, and Part 3 presents the econometric model, data and methodology. The empirical results of our work are discussed in Part 4, and Part 5 presents our conclusion. 2. LITERATURE REVIEW Most of the evidence for the measure of volatility related to the introduction of futures trading is coming from different studies for different countries and in various time periods. Plus, most studies examine the commodities rather than financial futures or options. During the last years, the empirical studies have focused on the financial futures trading. The results obtained don t give any clear view because of the differences in the nature of the stock markets, the different time periods and the fact that the introduction of derivatives can stabilize or destabilize the spot markets, as well. The destabilization of the stock markets refers to the increase of its volatility, while the stabilization refers to the decrease, or at least no change, of the underlying volatility. One possible reason leading to these different results is the speed that the new information is arriving because of the derivatives trading and the speed that this information is transmitted (Perold and Gammill, 1989). The main characteristics of the derivative markets are their higher liquidity, lower transaction costs and lower margins. For those reasons, the investors are able to act faster and more efficiently compared to their action in the cash markets. That means that the cash market volatility depends on the proportion of informed to uninformed investors (noise traders) migrating from the cash markets to the derivatives markets (Vipul, 2006). Most of the studies in the pertinent Centre for Financial Services Gujarat Technological University CCFS

3 literature have used GARCH-family models to ex-amine the volatility change after the introduction of derivatives trading in a market. There are studies covering mainly the U.S. market as well as other developed markets in the USA, in Asia and in Europe. It is evident from this extensive literature that the country, the time period and the economic conditions, as well as the various models used for the analysis play a significant role for the controversial results that exist regarding the effect of the introduction of derivatives trading on the spot market s volatility. Various studies have given different results with respect to the effect of futures on the spot market volatility. Several theoretical arguments have been used to explain the consequences of the futures introduction of futures in the spot market. A variety of models such as those in the GARCH family models try to explain whether the introduction of a futures market stabilizes or destabilizes the volatility of the spot market. Cox (1976) found that the uninformed speculators participating in the derivatives markets increase the volatility of the spot market prices. Finglewski (1981) examining the impact of futures trading in the Government National Mortgage Association (GNMA) by using the standard deviations of the returns. Stein (1987) also concluded that the derivatives are responsible for the destabilization of the underlying spot market. Aggarwal (1988) and Harris (1989) supported that the volatility of the period after the introduction of futures was higher. Maberly et al. (1989) found that the volatility of the S&P500 index was higher for the period after the introduction of futures. Lockwood and Lim (1990) found that the volatility in the spot market increased because of the introduction of futures trading. Brorsen (1991) reached the same result and he found that volatility was higher after the futures entered the stock markets. Lee and Ohk (1992) examined the effect of the introduction of the futures trading on the volatility of the market in Japan, Hong Kong, the UK, the USA and Australia. Except for the markets of Australia and Hong Kong, they concluded that the volatility of the stock market increased after the introduction of futures trading. Kamara et al. (1992) sup-ported the proposition that the beginning of futures market trading destabilizes the spot market by increasing the volatility by examine the S&P500 index in the US market.chang et al. (1995) used the same methods and concluded that there is an increase in volatility only at the close of the futures market and especially in the last 15 minutes. Butterworth (1998), found also that derivatives can cause destabilization of the spot market and that volatility increased for the FTSE Mid 250 index in the UK market. Gulen and Mayhew (2000) reached the same results. Yu (2001), by using a switching GARCH(1,1)-MA(1) model, for the US, French, Japanese, Australian, the UK and Hong Kong markets, found slightly different results. For the markets of the USA, Japan, Australia and France, he found that the underlying spot market volatility increased, similarly with the previously mentioned studies. However, for the markets of Hong Kong and the UK, he found no significant relationship between change in volatility and futures. Chiang and Wang (2002), for the TAIEX futures in Taiwan supported all the previous propositions. In more recent studies, Pok and Poshakwale (2004) and Ryoo and Smith (2004), after examination of the Malaysian and the Korean markets respectively, found that the increased volatility of the underlying spot market was due to the introduction of futures market. In contrast to the above studies that suggested that the futures markets are responsible for the increased volatility of the underlying spot markets, other studies reached the conclusion that the volatility in the post-introduction period, the period after the introduction of derivatives, is decreased relatively to the volatility of the pre-introduction period. 168 Centre for Financial Services Gujarat Technological University CCFS2014

4 Edwards (1988) after examining the introduction of S&P500 futures contracts, he found that this is responsible for the reduced volatility in the post-introduction period. Freris (1990) examined the Hang Seng index of the Hong Kong market and found also that the stock market volatility was decreased after the introduction of futures. Brown-Hruska and Kuserk (1995) studied the volatility of the S&P500 index after the introduction of stock index futures markets and found that futures markets decrease the stock market volatility. The future markets may increase the market s depth and liquidity and so, the volatility may decrease. Antoniou and Holmes (1995) support that the arrival of futures trading de-pends on the information of the market speculators. More precisely, if the speculators have perfect information, the futures introduction stabilizes the spot prices. Otherwise, there is a destabilizing effect. Antoniou et al. (1998) suggested that the futures trading have a significant negative effect on the volatility of the spot market in Germany and Switzerland. Chatrath et al. (1995) using the S&P100 US index and Pericli and Koutmos (1997), using the S&P500 index concluded the same. Galloway and Miller (1997) found similar results after the examination of the Mid-cap 400 index and Cohen (1999) for the US, the Japanese and the British market reinforced this outcome. In their research for the Spanish market, Pilar and Rafael (2002) used the GJR model with a dummy variable and they concluded that the derivatives markets decrease the volatility of the underlying market based on the Spanish Ibex35 index. Bologna and Cavallo (2002), studied the Italian market s volatility and found that the stock market volatility was lower after the establishment of the futures contracts trading markets. Their research is based on the examination of the Italian MIB30 index and on the basic GARCH equation with and without a dummy variable. Finally, Floros and Vougas (2006), regarding the spot market volatility of the FTSE/ASE-20 and the FTSE/ASE-Mid40 indices of the Greek stock market for the period , found that it decreased by the introduction of derivatives trading. There are many other studies suggesting that there is no significant effect of the introduction of futures trading on the spot market volatility of the underlying index. Santoni (1987) for the S&P500, Davis and White (1987) as well as Edwards (1988a, b) reached the same conclusion. Hodgson and Nicholls (1991) for the Australian stock market, Baldauf and Santoni (1991) and Seguin (1992), said that there is no significant relationship be-tween the futures trading and the volatility of the S&P500 index. Antoniou et al. (1998) found that the futures markets have no effect on the underlying volatility for the Japanese, Spanish, British and American markets. Dennis and Slim (1999) used an exponential asymmetric ARCH model for the Australian market and found that the impact of the introduction of futures trading on the underlying spot market volatility was not significant. Kan (1999) studied a different mar-ket, namely that of Hong Kong, over the period and he also reached similar conclusions in his research on the stocks volatility of the HIS index. Becchetti and Caggese (2000) suggested that the introduction of futures trading market increased the volatility in the German market, had no effect in the UK, Swiss, French and Austrian markets and decreased the volatility in the Dutch market. Rahman (2001) found no significant correlation between the conditional volatility of the Dow Jones Industrial Average stocks index and the futures trading on this index. Darrat et al. (2002) having embodied more macroeconomic variables and employing a different methodology, reached no different conclusions. Finally, Illenca and Lafuente (2003) found the same results for the Spanish market efficiency by applying a bivariate error correction GARCH model with a dummy variable. Centre for Financial Services Gujarat Technological University CCFS

5 3. DATA AND METHODOLOGY Daily data for BSE Sensex and S&P CNX Nifty have been used for the period January 1995 to March Along with these two series on which derivative products are available, we also consider the volatility on the broad based BSE-100 and Nifty Junior on which derivative products have not been introduced. Though BSE and NSE prices are tightly bound by arbitrage, the derivative turnover differs considerably among these markets (with the NSE recording a maximum turnover in the derivative market). A comparison of fluctuations in volatility between BSE- 100/Nifty Junior and Sensex / Nifty may provide a clue to segregate the fluctuations due to introduction of future products and due to other market factors. There are several broad based indices available like BSE-100, BSE-200, BSE-500 and Nifty Junior. However, longer time series is available only for Nifty Junior and BSE 100. These indices also capture 80 to 90 per cent of market capitalisation of the BSE or the NSE and therefore, they are chosen as surrogate indices. The empirical exercise attempts to evaluate whether the introduction of index futures had any significant impact on the spot stock return volatility. It uses the daily BSE Sensex returns and daily S&P CNX Nifty returns along with returns on BSE-100, to evaluate the impact of these policy changes on the stock returns volatility. Following Bolognaand Cavallo (2002), this paper uses Generalised Autoregressive Conditional Heteroscedasticity (GARCH) framework to model returns volatility. In India, futures trading on the S&P CNX Nifty Index of the NSE and the BSE Sensex Index of the BSE started in June Majority of derivative trading volume held with NSE therefore, in this research the S&P CNX Nifty Index is taken to study the volatility behaviour of the market. This study uses the daily closing prices of the Spot Nifty Index, the Nifty Index Futures, the Nifty Junior Index from 1st January 1995, through December, The S&P CNX Nifty spot and futures and the Nifty Junior Index price data were collected from the NSE website ( The closing price data were converted to daily compounded returns by taking the first log difference. 3.1 Average daily return Return Rt at time t is given by 1ln (/)*100tttRPP =, where Pt is the closing price for day t. One of the two components of the total daily return generated of a stock. Intraday return measures the return generated by a stock during regular trading hours, based on its price change from the opening of a trading day to its close. Intraday return and overnight return together constitute the total daily return from a stock, which is based on the price change of a stock from the close of one trading day to the close of the next trading day. Also called daytime return. 170 Centre for Financial Services Gujarat Technological University CCFS2014

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