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The effect of introduction of derivatives on the volatility of the spot markets and in turn, its role in stabilising or destabilising

the
DERIVATIVES AND VOLATILITY ON INDIAN STOCK MARKETS 189

cash markets has remained an active topic of analytic and empirical interest. Questions pertaining to the impact of derivative trading on cash market volatility have been empirically addressed in two ways: by comparing cash market volatilities during the pre-and post-futures/ options trading eras and second, by evaluating the impact of options and futures trading (generally proxied by trading volume) on the behaviour of cash markets. The literature is, however, inconclusive on whether introduction of derivative products lead to an increase or decrease in the spot market volatility. One school of thought argues that the introduction of futures trading increases the spot market volatility and thereby, destabilises the market (Cox 1976; Figlewski 1981; Stein, 1987). Others argue that the introduction of futures actually reduces the spot market volatility and thereby, stabilises the market (Powers, 1970; Schwarz and Laatsch, 1991 etc.). The rationale and findings of these two alternative schools are discussed in detail in this section. The advocates of the first school perceive derivatives market as a market for speculators. Traders with very little or no cash or shares can participate in the derivatives market, which is characterised by high risk. Thus, it is argued that the participation of speculative traders in systems, which allow high degrees of leverage, lowers the quality of information in the market. These uninformed traders could play a destabilising role in cash markets (Chatrath, Ramchander and Song, 1995). However, according to another viewpoint, speculation could also be viewed as a process, which evens out price fluctuations. The debate about speculators and the impact of futures on spot price volatility suggests that increased volatility is undesirable. This is, however, misleading as it fails to recognise the link between the information and the volatility (Antoniou and Holmes, 1995). Prices depend on the information currently available in the market. Futures trading can alter the available information for two reasons: first, futures trading attract additional traders in the market; second, as transaction costs in the futures market are lower than those in the
190 RESERVE BANK OF INDIA OCCASIONAL PAPERS

spot market, new information may be transmitted to the futures market more quickly. Thus, future markets provide an additional route by which information can be transmitted to the spot markets and therefore, increased spot market volatility may simply be a consequence of the more frequent arrival and more rapid processing of information. On the other hand, arguments suggesting that the future and option markets have become important mediums of price discovery in cash markets are equally strong. Several authors have argued that

trading in these products improve the overall market depth, enhance market efficiency, increase market liquidity, reduce informational asymmetries and compress cash market volatility (Kumar, Sarin and Shastri, 1995; Antoniou, Holmes and Priestley, 1998). It has been argued that the introduction of derivatives would cause some of the informed and speculative trading to shift from the underlying cash market to derivative market given that these investors view derivatives as superior investment instruments. This superiority stems from their inherent leverage and lower transaction costs. The migration of informed traders would reduce the information asymmetry problem faced by market makers resulting in an improvement in liquidity in the underlying cash market. In addition, it could also be argued that the migration of speculators would cause a decrease in the volatility of the underlying cash market by reducing the amount of noise trading. The effect of introduction of derivatives on the volatility of the spot markets and in turn, its role in stabilising or destabilising the
DERIVATIVES AND VOLATILITY ON INDIAN STOCK MARKETS 189

cash markets has remained an active topic of analytic and empirical interest. Questions pertaining to the impact of derivative trading on cash market volatility have been empirically addressed in two ways: by comparing cash market volatilities during the pre-and post-futures/ options trading eras and second, by evaluating the impact of options and futures trading (generally proxied by trading volume) on the behaviour of cash markets. The literature is, however, inconclusive on whether introduction of derivative products lead to an increase or decrease in the spot market volatility. One school of thought argues that the introduction of futures trading increases the spot market volatility and thereby, destabilises the market (Cox 1976; Figlewski 1981; Stein, 1987). Others argue that the introduction of futures actually reduces the spot market volatility and thereby, stabilises the market (Powers, 1970; Schwarz and Laatsch, 1991 etc.). The rationale and findings of these two alternative schools are discussed in detail in this section. The advocates of the first school perceive derivatives market as a market for speculators. Traders with very little or no cash or shares can participate in the derivatives market, which is characterised by high risk. Thus, it is argued that the participation of speculative traders in systems, which allow high degrees of leverage, lowers the quality of information in the market. These uninformed traders could play a destabilising role in cash markets (Chatrath, Ramchander and Song, 1995). However, according to another viewpoint, speculation could also be viewed as a process, which evens out price fluctuations. The debate about speculators and the impact of futures on spot price volatility suggests that increased volatility is undesirable. This is, however, misleading as it fails to recognise the link between the information and the volatility (Antoniou and Holmes, 1995). Prices

depend on the information currently available in the market. Futures trading can alter the available information for two reasons: first, futures trading attract additional traders in the market; second, as transaction costs in the futures market are lower than those in the
190 RESERVE BANK OF INDIA OCCASIONAL PAPERS

spot market, new information may be transmitted to the futures market more quickly. Thus, future markets provide an additional route by which information can be transmitted to the spot markets and therefore, increased spot market volatility may simply be a consequence of the more frequent arrival and more rapid processing of information. On the other hand, arguments suggesting that the future and option markets have become important mediums of price discovery in cash markets are equally strong. Several authors have argued that trading in these products improve the overall market depth, enhance market efficiency, increase market liquidity, reduce informational asymmetries and compress cash market volatility (Kumar, Sarin and Shastri, 1995; Antoniou, Holmes and Priestley, 1998). It has been argued that the introduction of derivatives would cause some of the informed and speculative trading to shift from the underlying cash market to derivative market given that these investors view derivatives as superior investment instruments. This superiority stems from their inherent leverage and lower transaction costs. The migration of informed traders would reduce the information asymmetry problem faced by market makers resulting in an improvement in liquidity in the underlying cash market. In addition, it could also be argued that the migration of speculators would cause a decrease in the volatility of the underlying cash market by reducing the amount of noise trading.v 1. Introduction
The issue of the impact of derivative trading on stock market volatility has received considerable attention during past few years. Although many factors contribute to stock market volatility, there is concern about the impact of derivative trading on stock market volatility. A large number of theoretical and empirical studies have examined the effect of stock index futures and options on the volatility of the underlying spot market. Some researchers have argument that introduction of derivatives affect the volatility of stock market while others disagree with the statement. The derivatives were launched mainly with the twin objective of risk transfer and to increase liquidity thereby ensuring better market efficiency. In India, derivatives trading started in June 2000 with introduction of Index future followed by index options in June 2001, and options and futures on individual securities in July 2001 and November 2001, respectively. Since inception, National Stock Exchange of India (NSE) established itself as the sole market leader in this segment in the country and during 2008-09, it accounted for 99 % of the market share (NSE, 2009). The total turnover on the F&O Segment was Rs. 11,010,482 crore (US $ 2,161,037 million) during 2008-09.The average daily turnover during 2008-09 was Rs.45, 311 crore (US $ 8,893 million).

The introduction of derivative products may increase volatility in component stocks. This is because the spot and future markets are linked through risk transfer (hedging) and price discovery, two major contributions of the futures markets to economic activity(Rahman,2001). Theoretically, the impact of stock index futures and options on the stock market volatility is still not clear. The linkage between these derivatives markets and the stock market is generally established through arbitraging activities. The study of impact of derivative trading is important as increased spot market volatility resulting from futures trading may suggest a need for more regulations. The findings of the study will be useful for investors to make investment decision.

2. Literature Review
Various studies are conducted on impact of derivative trading on the volatility of stock market all over the world. Previous studies document mixed evidences on the impact of derivative trading on the stock market volatility. Several studies have attempted to examine the behavior of stock market after introduction of derivatives. Debashis (2008) studied the effect of future trading on volatility & operating efficiency of the underlying Indian stock market by using paired sample statistic and found that introduction of Nifty Index Future trading in India is associated