Master of Business Administration

Impact Of Futures And Options Trading On Nifty Stocks Systematic Risk & Volatility
A Research Report
On
Impact of the Futures and Options Trading on Nifty Stocks Systematic Risk and Volatility
Submitted in partial fulfillment of requirement for the award of the degree of
Master of Business Administration

Of Bangalore University By SALONI Reg. No: 07XQCM6088
Under the Guidance and Supervision Of

Prof.N.S.MALAVALLI
M.P.BIRLA INSTITUTE OF MANAGEMENT

Associate Bharathiya Vidya Bhavan #43, Race Course Road, BANGALORE-560001
1 M.P. Birla Institute Of Management
Abstract :
Among all the innovations that have flooded the international financial markets, financial derivatives occupy the driver's seat. Derivatives are financial instruments whose values depend on the values of underlying assets. In India, stock futures and options trading were started by the National Stock Exchange with a view to bring stability in the market for commodities and to keep a check on the spiraling prices of shares. The underlying research work aims at finding out impact of stock futures and options on the spot market volatility or whether after introduction of stock futures have fluctuated drastically compared to before the introduction of stock futures and options.
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The objective of the study is to find out whether the introduction of Index stocks futures and options has any impact on the systematic risk and volatility of the stocks. This is done by considering the before introduction closing prices of index stocks and after introduction closing prices of index stocks. Using beta systematic risk is calculated and using the simple standard deviation model the volatilities are calculated. F-test is used for find whether they are significant or not.
Specifically, it is found that new information is assimilated into prices more rapidly than before, and there is a decline in the persistence of volatility since the onset of futures and options trading. The findings of the study are systematic risk and average variation seems to reduce statistically .It is found that our alternate hypothesis is true, that is, introduction of derivatives has reduced the systematic risk and volatility in the index stocks.
INTRODUCTION
Introduction :
In the last decade, many emerging and transition economies have started introducing derivative contracts. These specialized instruments facilitate the shuffling and redistribution of the innumerable risks that an investor face and, thus aids in the process of diversifying ones portfolio.. The volatility in the equity markets over the past years has resulted in greater use of equity derivatives. The volume of the exchange traded equity futures and options in most of the mature markets have seen a significant growth.
It goes beyond doubt that the local derivative markets in the emerging markets have witnessed widespread use of the derivative instrument for a variety of reasons. This continuous growth and development by the emerging market participants has resulted in capital inflows as well as helped the investors in risk protection through hedging. The derivatives were launched mainly with the twin objective of risk transfer and liquidity and thereby ensuring better market efficiency. It is important, from both theoretical and practical perspective, to examine how far these objectives have materialized. Volatility is yet another area of interest both for regulators and for market participants. Regulators and market participants prefer less volatility to more volatility. Financial derivatives are expected to reduce volatility in the spot market as speculators move away from spot market to financial futures market.
Derivatives :
Derivative is a product whose value is derived from the value of one or more basic variables, called bases i.e. underlying asset, index, or reference rate, in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.
Derivatives are used by :

1. Hedgers : For protecting against adverse movement, hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk.
2. Speculators: To make quick fortune by anticipating/forecasting future market movements. Hedgers wish to eliminate or reduce the price risk to which they are already exposed. Speculators, on the other hand are those class of investors who willingly take price risks to profit from price changes in the underlying. While the need to provide hedging avenues by means of derivative instruments is laudable, it calls for the existence of speculative traders to play the role of counter-party to the hedgers. It is for this reason that the role of speculators gains prominence in a derivatives market.
3. Arbitrageurs: To earn risk-free profits by exploiting market imperfections , Arbitrageurs profit from price differential existing in two markets by simultaneously operating in the two different markets.
Functions :
1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.
2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.
3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade
in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.
5. Derivative acts as a catalyst for new entrepreneurial activity i.e. it has a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.
6. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
Types of Derivatives :
Derivatives are basically classified into two based upon the mechanism that is used to trade on them. 1. Over the Counter derivatives 2. Exchange traded derivatives
Classification of Derivatives :
The financial Derivatives Products can be classified as 1. Forward 2. Futures 3. Option 4. SWAP
Forward :
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.
Futures :
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. These contracts are traded on exchanges. In a nutshell futures markets are the extension of the forward contracts. These markets being organized/standardized are very liquid by their own nature. Therefore, liquidity problem, which persists in the forward market, does not exist in the futures market. In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades i.e.: assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing
corporation/house.
Option :
An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific price on or before a specified time. The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil etc. or financial instruments like equity stocks/ stock index/ bonds etc.
Swap :
Swap can be defined as "A financial transaction in which two counterparties agree to exchange streams of payments, or cash flows, over time". Generally, two types of swaps are generally seen i.e. interest rate swaps and currency swaps. A swap results in reducing the borrowing cost of both parties.
Derivatives market in India:

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of
securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements. The SCRA was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the threedecade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individualstocks were launched in November 2001. Trading and settlement in derivative contracts is done in accordance with the rules, bye laws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette.
Derivatives market at NSE :

The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Currently, the futures contracts have a maximum of 3-month expiration cycles. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.. The derivatives turnover on the NSE has surpassed the equity market turnover.
The turnover of derivatives on the NSE increased from Rs. 23,654 million (US $ 207 million) in 2000-01 to Rs. 130,904,779 million (US $ 3,275,076 million) in 2007-08. India is one of the most successful developing countries in terms of a vibrant market for exchange-traded derivatives. This reiterates the strengths of the modern development of Indias securities markets, which are based on nationwide market access, anonymous electronic trading, and a predominantly retail market. The factors that have been driving the growth of financial derivatives worldwide, as also in India are increased volatility in asset prices in financial markets; increased integration of national financial markets with international markets; development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies and innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets.
Trading mechanism:
The futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screenbased trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict pricetime priority. It is similar to that of trading of equities in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed by two types of users. The Trading Members(TM) have access to functions such as order entry, order matching, and order & trade management. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. Various conditions like Good-till-Day, Good-tillCancelled, Good-till- Date, Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The Clearing Members (CM) use the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can take.
LITREATURE REVIEW
Introduction :
The impact of futures and options on the underlying index volatility seems practically an empirical question. A number of studies have been carried out in this regard across the countries. Generally, two types of arguments prevail in the existing literature. One school of thought argued that derivatives trading increases stock market volatility due to high degree of leverage and hence, destabilizes the market. Further, futures market is likely to attract uniformed traders due to low transactions costs involved to take positions in the futures market. The lower level of information of derivatives trades with respect to cash market traders is likely to increase the asset volatility. On the other hand, another school of thought claims that futures market plays an important role of price discovery and has beneficial effect on the underlying cash market. Kumar et al (1995) argued that derivatives trading helps in price discovery, improves the market debt, enhances market efficiency and reduces asymmetry information of spot market. This gives rise to the controversy among the researchers, academicians and investors on the effect of derivatives on the underlying market volatility .
The below literature gives a mixed result about the effect of futures on the volatility of the underlying market across the countries. The results depend on the indices and methodology used in the study, because studies examine the same indices arrived at different conclusions. Most of the studies are related to the developed countries like the USA, the UK or Japan. But, a very few studies have been conducted in developing countries like India.
Survey Of The Empirical Literature :

The introduction of equity index futures markets enables traders to transact large volumes at much lower transaction costs relative to the cash market. The consequence of this increase in order flow to futures markets is unresolved on both a theoretical and an empirical front. Stein (1987) develops a model in which prices are determined by the interaction between hedgers and informed speculators. In this model, opening a futures market has two effects; (1). The futures market improves risk sharing and therefore reduces price volatility, and (2). If the speculators observe a noisy but informative signal, the hedgers react to the noise in the speculative trades, producing an increase in volatility.
In contrast, models developed by Danthine (1978) argue that the futures markets improve market depth and reduce volatility because the cost to informed traders of responding to mispricing is reduced. Froot and Perold(1991) extend Kyle.s(1985) model to show that market depth is increased by more rapid dissemination of market-wide information and the presence of market makers in the futures market in addition to the cash market. Ross (1989) assumes that there exists an economy that is devoid of arbitrage and proceeds to provide a condition under which the no-arbitrage situation will be sustained. It implies that the variance of the price change will be equal to the rate of information flow. The implication of this is that the volatility of the asset price will increase as the rate of information flow
increases. Thus, if futures increase the flow of information, than in the absence of arbitrage opportunity, the volatility of the spot price must change. Overall, the theoretical work on futures listing effects offer no consensus on the size and the direction of the change in volatility. We therefore need to Turn to the empirical literature on evidence relating to the volatility effects of listing index futures and options.
IMPACT OF FUTURES INTRODUCTION ON UNDERLYING INDEX VOLATALITY: AN EVIDENCE FROM INDIA Kotha Kiran Kumar. & Chiranjit Mukhopadhyay
Introduction :
This paper addresses whether, and to what extent, the introduction of Index Futures contracts trading has changed the volatility structure of the underlying NSE Nifty Index. One of the most recurring themes in empirical financial research is studying the effect of Derivatives trading on the underlying asset. Special interest is devoted to studying whether Derivatives markets stabilize or destabilize the underlying markets. Many theories have been advanced on how the introduction of Derivatives market might impact the volatility of an underlying asset. The traditional view against the Derivatives markets is that, by encouraging or facilitating speculation, they give rise to price instability and thus amplify the spot volatility. This is called the Destabilization hypothesis. This has led to call for greater regulation to minimize any detrimental effect. An alternative explanation for the rise in volatility is that Derivatives markets provide an additional route by which information can be
transmitted, and therefore, increase in spot volatility may simply be a consequence of the more frequent arrival, and more rapid processing of information. Thus Derivatives trading may be fully consistent with efficient functioning of the markets. Stock index futures, because of operational and institutional properties, are traditionally more volatile than spot markets. The close relationship between the two markets induces the possibility of transferring volatility from futures markets to the underlying spot markets. There are numerous studies that have approached the effect of the introduction of Index Futures trading from an empirical perspective. Majority of the studies compare the volatility of the spot index or individual component stocks in an index before and after the introduction of the futures contract using different methodologies ranging from simple comparison of variances, to linear regression to more complex GARCH models with different underlying assumptions and parameters in the models. Most of the studies examined the impact of introduction of index futures in one market and thus were unable to compare across markets. Gulen and Mayhew (2000) examine stock market volatility before and after the introduction of index futures trading in twenty-five countries, using various GARCH models augmented with either additive or multiplicative dummy. Their statistical model takes care of asynchronous data, conditional heteroskedasticity, asymmetric volatility responses, and the joint dynamics of each countrys index with the world market portfolio. They found that futures trading are related to an increase in conditional volatility in the U.S. and Japan, but in nearly every other country, no significant effect could be found. Most of these studies examined the impact
of introduction of index futures in one market and thus were unable to compare across markets. Gulen and Mayhew (2000) examine stock market volatility before and after the introduction of index futures trading in twentyfive countries, using various GARCH models augmented with either additive or multiplicative dummy. Their statistical model takes care of asynchronous data, conditional heteroskedasticity, asymmetric volatility responses, and the joint dynamics of each country.s index with the world market portfolio. They found that a futures trading is related to an increase in conditional volatility in the U.S. and Japan, but in nearly every other country, no significant effect could be found. The study in this article improves the earlier studies in five aspects, first two are in general context and the others are in Indian context. First, the paper examines closely whether there is any shift in the NSE Nifty volatility in the period under investigation through a change-point analysis and then confirms that indeed a change has occurred around the date of introduction of Index Futures trading. To the authors knowledge no other study has thus objectively validated the event-study methodology, typically applied in studying problems of the kind discussed in this paper. Secondly, marginal volatilities of before and after series are compared apart from the well documented comparison of conditional volatility of a series before and after occurrence of an event. The volatility comparison through GARCH model gives whether the conditional volatility of the series (which is same as that of residuals) has changed or not and does not comment on the volatility of the underlying series as such. Third, this study applies the GARCH model, which inherently incorporates endogenous information in the expression of conditional
volatility as discussed in Ross (1989), apart from effectively controlling the temporal dependency phenomena. Following Antoniou & Holmes (1995), the GARCH model is augmented with individual dummies. The use of individual dummies is important as one can measure whether there is a change in the speed and persistence with which volatility shocks evolve after the futures trading1. Fourth, this paper deviates from the existing literature on the studies of the Indian markets in using Nifty Junior index as a proxy for market-wide movements given that it contributes a mere 6% on average, of market capitalization. Instead, MSCI World Index has been used to control for market-wide movements. Fifth, the entire test procedure is implemented on Nifty Junior, which does not have corresponding futures contract and thus may be treated as a control index. This strengthens the analysis of impact of Index Futures trading on Nifty as its results differ from that of Nifty Junior. The study reports that while there is no change in the mean returns and marginal volatility there is a substantial change in the dynamics by which the conditional variance evolves. Specifically, the results suggest that a future trading improves the quality and speed of information flow to spot market and this trend is not evident in the control index, NSE Nifty Junior.
Methodology :
Any test applied to measure the effects of an intervention, such as the introduction of futures trading, requires the knowledge of when the intervention took place, followed by an analysis of the behavior of the spot market before and after the event. The classic Event-study methodology is applied to study the impact of introduction of index futures trading on the
volatility of NSE Nifty Index. However before blindly initiating the event study methodology, one has to first check whether there is indeed any change in the series under study, around the event date without using its prior knowledge, through a Change-Point Analysis. For this purpose an informal descriptive statistical technique called CUSUM (Cumulative Sum) chart is employed, which has been widely used in Statistical Process Control literature for change-point detection, (vide., Ch 7 of Montgomery, 1991) and as well as a formal Bayesian analysis. If there is any shift in the spot volatility because of Futures introduction then the date obtained from CUSUM plot or the Bayesian analysis should approximately coincide with that of the actual starting date of Futures trading.
Cusum Chart :
A segment of the CUSUM chart with an upward slope indicates a period where the values tend to be above the overall average. Likewise a segment with a downward slope indicates a period of time where the values tend to be below the overall average. Thus a sudden change in direction of the CUSUM indicates a sudden shift or change in the average. Fig 1 shows the CUSUM chart with NSE Nifty daily squared returns, as a proxy for volatility, from June 1999 to June 2001. As is evident from the CUSUM chart, the NSE Nifty squared returns have taken a sudden turn on 6th June 2000. Incidentally, BSE Sensex Futures started on 5th June 2000 and NSE Nifty Futures started on 12th June 2000. So around the date of introduction of Futures there has been a sudden turn in NSE Nifty daily squared returns and needs further examination to conclusive evidence. From the CUSUM chart one may suspect that there is an abrupt change in the volatility of the Nifty series around the futures introduction. However it
may be argued that the spike found around the date of futures introduction may only be due to the natural variability of the Nifty series. Thus the change point analysis is also approached from a Bayesian viewpoint to see if one can statistically infer that there indeed exists a change in the volatility process of NSE Nifty without utilizing the knowledge of exact date of introduction of futures trading.
Bayesian approach:
From the CUSUM chart one may suspect that there is an abrupt change in the volatility of the Nifty series around the futures introduction. However it may be argued that the spike found around the date of futures introduction may only be due to the natural variability of the Nifty series. Thus the change point analysis is also approached from a Bayesian viewpoint to see if one can statistically infer that there indeed exists a change in the volatility process of NSE Nifty without utilizing the knowledge of exact date of introduction of futures trading.
Controlling Other Factors:

The next step is the choice of the length of test period or the length of the estimation window. The choice of the length of the test period is a critical question where a balance needs to be struck between the length of the period for reliable estimation of model parameters, against the possibility of existence of other events that might affect the series and thus the parameter estimates. The later is because stock markets are usually affected by a number of other events over a period of time, which are distinct from the event in question. Thus there is a problem of confounding by other intervening variables. The effects of these events on volatility are uncertain and
disentangling these intervening events and extracting a normal model of expected volatility is not a simple task. Two methods are used to guard against drawing erroneous conclusion about the shift in volatility due to introduction of index futures trading, which in reality might be attributed to other factors. First, the MSCI World index is used to control for market-wide movements. Second, a control procedure is undertaken by implementing the entire test procedure on a similar index that did not have any derivative trading. If the NSE Nifty exhibits a change while the control index does not, then the conclusions drawn with respect to the impact of the introduction of the index futures trading on the NSE Nifty are strengthened. Given that index futures contracts have been introduced on the most popular and broad measure of Indian stock market, the choice of control index should typically be the next largest index. Towards this end, NSE Nifty Junior is chosen as the control index, which does not have futures trading yet. The theoretical framework of analyzing the change in volatility is described in the next sub-section.
Marginal Volatility Comparison :

Though the GARCH framework explicitly model how the conditional volatility evolves over time, it does not comment on change in volatility of the series as a whole, which is the primary objective of the study. Further the conditional volatility of the series or residuals by definition depends on the past information and hence unable to conclude on the overall volatility pattern of the series. This is accomplished by calculating the marginal volatility of the series, which is derived from the ARMA-GARCH model.
Conclusion :
This paper investigates whether and to what extent the introduction of Index Futures trading has had an impact on the mean level and volatility of the underlying NSE Nifty Index. The results reported for the NSE Nifty indicate that while the introduction of Index Futures trading has no effect on mean level of returns and marginal volatility, it has significantly altered the structure of spot market volatility. Specifically, there is evidence of new information getting assimilated and the effect of old information on volatility getting reduced at a faster rate in the period following the onset of futures trading. This result appears to be robust to the model specification, asymmetric effects, sub-period analysis and market-wide movements. These results are consistent with the theoretical arguments of Ross (1989).
BEHAVIOUR OF STOCK MARKET VOLATILITY AFTER DERIVATIVES
Golaka C Nath Introduction :

The introduction of equity and equity index derivative contracts in Indian market has not been very old but today the total notional trading values in derivatives contracts are much ahead of cash market. On many occasions, the derivatives notional trading values are double the cash market trading values. Given such dramatic changes, we would like to study the behaviour of volatility in cash market after the introduction of derivatives. Impact of
derivatives trading on the volatility of the cash market in India has been studied by Thenmozhi(2002), Shenbagaraman(2003), Gupta and Kumar (2002). Gupta and Kumar(2002) did find that the overall volatility of underlying market declined after introduction of derivatives contracts on indices. Thenmozhi(2002) reported lower level volatility in cash market after introduction of derivative contracts. Shenbagaraman(2003) reported that there was no significant fall in cash market volatility due to introduction of derivatives contracts in Indian market. Raju and Karande (2003) reported a decline in volatility of the cash market after derivatives introduction in Indian market. All these studies have been done using the market index and not individual stocks. These studies were conducted using data for a smaller period and when the notional trading volume in the market was not significant and before tremendous success of futures on individual stocks. Today derivatives market in India is more successful and we have more than 3 years of derivatives market. Hence the present study would use the longer period of data to study the behaviour of volatility in the market after derivatives was introduced. The study would use indices as well as individual stocks for analysis.
Methodology :
This study uses the daily stock market data from January 1999 (for IGARCH data used is from January 1998) to October 2003. Thus the daily returns are calculated using the following equation:
Rt = Log(Pt / Pt -1) *100 (1) where Rt is the daily return, Pt is the value of the security on day t and Pt-1 is the value of the security on day t-1.
Standard deviation of returns is calculated then. Where R is the average return over the period. This study calculates the rolling standard deviation for 1 year window as well as for a 6 month window to capture the conditional dynamics. Next volatility is calculated using Risk Metrics method with l = 0.94 (IGARCH) and the initial volatility was computed using one year data from January 1998 to December 1998. Then we have used a GARCH model to estimate the daily volatility. In the linear ARCH (q) model originally introduced by Engle (1982), the conditional variance ht is postulated to be a linear function of the past q squared innovations: In empirical applications of ARCH (q) models a long lag length and a large number of parameters are often called for. An alternative and more flexible lag structure is often provided by the generalized ARCH, or GARCH (p,q) model proposed independently by Bollerslev (1986) and Taylor (1986). In many applications especially with daily frequency financial data the estimate for a1 +a2 + ... +aq + b1 + b2 + ... + b p turns out to be very close to unity. Engle and Bollerslev (1986) were the first to consider GARCH processes with a1 + a2 + ... +a q + b1 + b2 + ... + b p = 1 as a distinct class of models, which they termed integrated GARCH (IGARCH). In the IGARCH class of models a shock to the conditional variance is persistent in the sense that it remains important for future forecasts of all horizons.
Data And Data Characteristics :

The study uses two benchmark indices: S&P CNX NIFTY and S&P CNX NIFTY JUNIOR along with selected few stocks for studying the volatility
behaviour during the period January 1999 to October 2003. 20 stocks have been considered a from the NIFTY and Junior NIFTY category. Out of the 20 stocks, 13 have single stock futures and options while 7 do not have the same. Futures and options are available on S&P CNX NIFTY but not on S&P CNX NIFTY Junior.
Conclusion :
The paper studies the behaviour of volatility in equity market in pre and post derivatives period in India using static and conditional variance. Conditional volatility has been modeled using four different method: GARCH(1,1), IGARCH with l = 0.94, one year rolling window of standard deviation and a 6 month rolling standard deviation. We have considered 20 stocks randomly from the NIFTY and Junior NIFTY basket as well as benchmark indices itself. Also static point volatility analysis has been used dividing the period under study among various time buckets and justified the creation of such time buckets. While studying conditional volatility it is observed that for most of the stocks, the volatility has come down in the post derivative period while for only few stocks in the sample (details are in Annexure II and III) the volatility in the post derivatives has either remained more or less same or has increased marginally. All these methods suggested that the volatility of the market as measured by benchmark indices like S&P CNX NIFTY and S&P CNX NIFTY JUNIOR have fallen after in the post derivatives period. The finding is in line with the earlier findings of Thenmozhi (2002), Shenbagaraman (2003), Gupta and Kumar (2002) and Raju and Karande
(2003). The earlier studies used shorter period of data and pre single stock futures and options period data while we have used data for a longer period that has taken into account various cyclical trends into consideration.
EFFECT OF INTRODUCTION OF INDEX FUTURES ON STOCK MARKET VOLATILITY: THE INDIAN EVIDENCE O.P. Gupta
Introduction :
The Indian capital market has witnessed a major transformation and structural change during the past one decade or so as a result of on going financial sector reforms initiated by the Government of India since 1991 in the wake of policies of liberalization and globalization. The major objectives of these reforms have been to improve market efficiency, enhancing transparency, checking unfair trade practices, and bringing the Indian capital market up to international standards. As a result of the reforms several changes have also taken place in the operations of the secondary markets such as automated online trading in exchanges enabling trading terminals of the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) to be available across the country and making geographical location of an exchange irrelevant; reduction in the settlement period, opening of the stock markets to foreign portfolio investors etc. In addition to these developments, India is perhaps one of the real emerging markets in South Asianregion that has introduced derivative products on two of its principal existing exchanges
viz., BSE and NSE in June 2000 to provide tools for risk management to investors. There had, however, been a considerable debate on the question of whether derivatives should be introduced in India or not. The L.C. Gupta Committee on Derivatives, which examined the whole issue in details, had recommended in December 1997 the introduction of stock index futures in the first place (1). The preparation of regulatory framework for the operations of the index futures contracts took another two and a half-year more as it required not only an amendment in the Securities Contracts (Regulation) Act, 1956 but also the specification of the regulations for such contracts. Finally, the Indian capital market saw the launching of index futures on June 9, 2000 on BSE and on June 12, 2000 on the NSE. A year later options on index were also introduced for trading on these exchanges. Later, stock options on individual stocks were launched in July 2001. The latest product to enter in to the derivative segment on these exchanges is contracts on stock futures in November 2001. Thus, with the launch of stock futures, the basic range of equity derivative products in India seems to be complete.
Methodology :
Following Ibrahim et al. [1999] and Kar et.al. [2000], the study has used four measures of volatility. The first measure is based upon close-to-close prices. Therefore, in the first place, the daily returns based on closing prices were computed using equation Rt = ln (Ct/Ct-1) (1) Where Ct and Ct-1 are the closing prices on day t and t-1 respectively; Rt represents the return in relation to day t. Next, we have computed the variance
of this return series to understand the inter-day volatility. The second measure of volatility is based upon open-to-open prices. Analogously, variance of the daily has been computed from returns series based on open-to-open prices. The third measure of volatility estimates intra31day volatility. It has been estimated by using Parkinson.s [1980] extreme value estimator, which is considered to be more efficient.
Data :
The data employed in the study consists of daily prices of two major stock market indices viz., the S&P CNX Nifty Index (henceforth Nifty Index) and the BSE Sensex (BSE Index) for a four year period from June 8, 1998 to June 30, 2002. For each of these indices four sets of prices were used. These were daily high, low, open, and close prices. Likewise, daily high, low, open, and close prices were used from June 9, 2000 to March 31, 2002 for the BSE Index Futures (7) and from June 12, 2000 to June 30, 2001 for the Nifty Index Futures. The necessary data have from collected from the Derivative Segments of both of these exchanges.
Conclusions :
This paper has been aimed at examining the impact of index futures introduction on stock market volatility. Further, it has also examined the relative volatility of spot market and futures market. The study utilized daily price data (high, low, open and close) for BSE Sensex and S&P CNX Nifty Index from June 1998 to June 2002. Similar data from June 9, 2000 to
March 31, 2002 have also been used for BSE Index Futures and from June 12, 2000 to June 30, 2002 for the Nifty Index Futures. The study has used four measures of volatility: (a) the first is based upon close-to-close prices, (b) the second is based upon open-to-open prices, (c)the third is Parkinson.s Extreme Value Estimator, and (d) the fourth is Garman-Klass measure volatility (GKV). The empirical results reported here indicate that the over-all volatility of the underlying stock market has declined after the introduction of index futures on both the indices in terms of all the three measures i.e. ln (Ct/Ct-1) ln (Ot/Ot-1) and ln (Ht/Lt). It must, however, be noted that since the introduction of index futures the Indian stock market has witnessed several changes in its market micro-structure such as the abolition of the traditional `badla system., reduction in the trading cycle etc. Therefore, these results should be interpreted in the light of these changes. However, there is no conclusive evidence, which suggests that, the futures volatility is highe(lower) in comparison to the underlying stock market for both the indices interms of all the four measures of volatility. In fact, there is some evidence that the futures volatility is lower in some months in comparison to the underlying stock market for both of these indices. These results are in contrast to those reported for the other emerging markets. The study, being first in the Indian context, has several policy implications for regulators, policy makers, and investors.
DO FUTURES AND OPTIONS TRADING INCREASE STOCK MARKET VOLATILITY? Dr. Premalata Shenbagaraman
Introduction :
In the last decade, many emerging and transition economies have started introducing derivative contracts. As was the case when commodity futures were first introduced on the Chicago Board of Trade in 1865, policymakers and regulators in these markets are concerned about the impact of futures on the underlying cash market. One of the reasons for this concern is the belief that futures trading attract speculators who then destabilize spot prices. This concern is evident in the following excerpt from an article by John Stuart
Mill (1871).The safety and cheapness of communications, which enable a deficiency in one place to be, supplied from the surplus of another render the fluctuations of prices much less extreme than formerly. This effect is much promoted by the existence of speculative merchant. Speculators, therefore, have a highly useful office in the economy of society. Since futures encourage speculation, the debate on the impact of speculators intensified when futures contracts were first introduced for trading; beginning with commodity futures and moving on to financial futures and recently futures on weather and electricity. However, this traditional favorable view towards the economic benefits of speculative activity has not always been acceptable to regulators. For example, futures trading was blamed by some for the stock market crash of 1987 in the USA, thereby
wrranting more regulation. However before further regulation in introduced, it is essential to determine whether in fact there is a causal link between the introduction of futures and spot market volatility. It therefore becomes imperative that we seek answers to questions like: What is the impact of derivatives upon market efficiency and liquidity of the underlying cash market? To what extent do derivatives destabilize the financial system, and how should these risks be addressed? Can the results from studies of developed markets be extended to emerging markets? This paper seeks to contribute to the existing literature in many ways. This is the first study to examine the impact of financial derivatives introduction on ash market volatility in an emerging market, India. Further, this study improves upon the methodology used in prior studies by using a framework that allows for generalized auto-regressive conditional heteroskedasticity (GARCH) i.e., it explicitly models the volatility process over time, rather than using estimated standard deviations to measure volatility. This estimation technique enables us to explore the link between information/news arrival in the market and its effect on cash market volatility. The study also looks at the linkages in ongoing trading activity in the futures market with the underlying spot market volatility by decomposing trading volume and open interest into an expected component and an unexpected (surprise) component. Finally this is the first study to our knowledge that looks at the effects of both stock index futures introduction as well as stock index options introduction on the underlying cash market volatility. The results of this study are crucial to investors, stock exchange officials and regulators. Derivatives play a very important role in the price discovery process and in completing the market. Their role in risk management for institutional investors and mutual fund
managers need hardly be overemphasized. This role as a tool for risk management clearly assumes that derivatives trading do not increase market volatility and risk. The results of this study will throw some light on the effects of derivative introduction on the efficiency and volatility of the underlying cash markets.
Methodology :
One of the key assumptions of the ordinary regression model is that the errors have the same variance throughout the sample. This is also called the homoskedasticity model. If the error variance is not constant, the data are said to be heteroskedastic. Since ordinary least-squares regression assumes constant error variance, heteroskedasticity causes the OLS estimates to be inefficient. Models that take into account the changing variance can make more efficient use of the data. There are several approaches to dealing with heteroskedasticity. If the error variance at different times is known, weighted regression is a good method. If, as is usually the case, the error variance is unknown and must be estimated from the data, one can model the changing error variance. In the past, studies of volatility have used constructed volatility measures like estimated standard deviations, rolling standard deviations, etc, to discern the effect of futures introduction. These studies implicitly assume that price changes in spot markets are serially uncorrelated and homoskedastic. However, findings of heteroskedasticity in stock returns are well documented (Mandelbrot 1963), Fama (1965), Bollerslev (1986). Thus the observed differences in variances from models assuming homoscedasticity may simply be due to the effect of return dependence and not necessarily due to futures introduction.The GARCH model assumes
conditional heteroscedasticity, with homoskedastic unconditional error variance. That is, the model assumes that the changes in variance are a function of the realizations of preceding errors and that these changes represent temporary and random departures from a constant unconditional variance, as might be the case when using daily data. The advantage of a GARCH model is that it captures the tendency in financial data for volatility clustering. It therefore enables us to make the connection between information and volatility explicit, since any change in the rate of information arrival to the market will change the volatility in the market. Thus, unless information remains constant, this is hardly the case, volatility must be time varying, even on a daily basis. The impact of stock index futures and option contract introduction in the Indian market is examined using a unvaried GARCH (1, 1) model. The time series of daily returns on the S&P CNX Nifty Index is modeled as a univariate GARCH process. Following Pagan and Schwert (1990) and Engle and Ng (1993), we need to remove from the time series any predictability associated with lagged world returns and/or day of the week effects. Further, it is required to control for the effect of market wide factors, since one is interested in isolating the unique impact of the introduction of the futures/options contracts. Fortunately for the Indian stock market there is an index, the Nifty Junior, which comprises stocks for which no futures contracts are traded. As such, it serves as a perfect control variable for us to isolate market wide factors and thereby concentrate on the residual volatility in the Nifty as a direct result of the introduction of the index derivative contracts. Therefore the study introduces the return on the Nifty Junior index as an additional independent variable.
Conclusion :
In this study one has examined the effects of the introduction of the Nifty futures and options contracts on the underlying spot market volatility using a model that captures the heteroskedasticity in returns that characterize stock market returns. The results indicate that derivatives introduction has had no significant impact on spot market volatility. This result is robust to different model specifications. However, futures introduction seems to have changed the sensitivity of nifty returns to the S&P500 returns. Also, the day-of-the week effects seem to have dissipated after futures introduction. Later the model is estimated separately for the pre and post futures period and finds that the nature of the GARCH process has changed after the introduction of the futures trading. Pre-futures, the effect of information was persistent over time, i.e. a shock to todays volatility due to some information that arrived in the market today, has an effect on tomorrow volatility and the volatility for days to come. After futures contracts started trading the persistence has disappeared. Thus any shock to volatility today has no effect on tomorrow.s volatility or on volatility in the future. This might suggest increased market efficiency, since all information is incorporated into prices immediately. Next, using a procedure inspired by Bessembinder and Sequin (1992), it is found that after the introduction of futures trading, one is unable to pick up any link between the volume of futures contracts traded and the volatility in the spot market.
RESEARCH METHODOLOGY
Research Problem Statement :

With the introduction of derivatives in the equity markets in the late nineties in the major world markets, the volatility behavior of the market has got complicated as the derivatives opens new avenues for hedging and speculation. In the Indian context, derivatives were mainly introduced with a view to curb the increasing volatility of the asset prices in financial markets. The concern over how trading in futures contracts affects the spot market for underlying assets has been an interesting subject for investors, market makers, academicians, exchanges and regulators alike The purpose of the study is to examine if there is any change in the systematic risk and volatility of Nifty index due to the introduction of derivatives.
Scope Of The Study :

The limited scope of the study is to find out: Whether the introduction of stock index Futures and options reduces stock market systematic risk and volatility.
Objective:
The objective of this study is to test, whether the introduction of Index Futures has had any impact on the systematic risk and volatility of Indian stock market.
Data:
Nature Of Data:
The nature of the data for the above study will be a time series secondary data.
Sources Of Data:
The data employed in the study consists of daily prices of the S@P CNX Nifty Index, for the period January 1999 to May 2003. The prices used are daily close prices. These data is collected from National Stock Exchange website.
Data Period :
Data is collected from January 1999 to May 2003.The sub- periods are : Pre Derivative Period : Jan 1999 to May 2000 Transition Period : June 2000 to Dec 2001 Post Derivative Period : Jan 2002 to May 2003
Hypothesis Of The Study :

H0 : Introduction of Index Stocks Futures and Options has no impact on the systematic risk and volatility of Spot Market. H1 : Introduction of Index Stocks Futures and Options has an impact on the systematic risk and volatility of Spot Market.
Methodology :
In this study to measure systematic risk beta is used. Beta is calculated from the closing stock prices of individual stocks and closing prices of nifty. Then
paired sample t test is used to test the significant difference among the sub periods. The procedure compares the means of two variables for a single group. It computes the differences between values of the two variables for each case and tests whether the average differs from zero.
To measure volatility of a stock standard deviation is used. We have calculated the standard deviation for the various period. We have used the closing stock prices of 15 companies from NSE INDIA website which have Futures and Options during the period January 1999 to May 2003. Then FTest is used to test significant difference among the sub periods.
Tools used for testing of hypothesis:

The following statistical tools were used to analyze the data:
1) Beta 2) T- test 3) Standard Deviation 4) F -Test
Beta :
Beta is used to measure systematic risk of a stock. The beta is calculated as follows:
Paired T-Test:
A t-test is any statistical hypothesis test in which the test statistic has a Student's t distribution if the null hypothesis is true. The paired t test provides an hypothesis test of the difference between population means for a pair of random samples whose differences are approximately normally distributed. Please note that a pair of samples, each of which are not from normal a distribution, often yields differences that are normally distributed.
The test statistic is calculated as:
where d bar is the mean difference, s is the sample variance, n is the sample size and t is a Student t quantile with n-1 degrees of freedom
Standard Deviation :
The standard deviation of closing prices of individual stocks for different time periods is calculated using the following methods:
F- TEST:
F TEST measures the ratio of the variances of two samples.
F- Test =
(Standard Deviation 1)2 (Standard Deviation 2)2
Software Packages Used :

1. Excel Spreadsheet
Limitations Of The Study:

1) The results may not give accurate picture as there could be many other factors which influence the volatility of Market Index.
2) Due to time constraint data of only few years could be taken.
DATA ANALYSIS AND INTERPRETATION
Empirical Results :
Daily closing prices for 15 companies were obtained from www.nseindia.com over the period 1st January to 31st May 2003.Continuously compounded percentage returns are estimated as the log price relative. That is for an stock with daily closing price Pt, its return Rt is defined as log (Pt/Pt-1). The return series is used to calculate beta while for volatility daily closing prices are used.
Figures showing individual stocks daily closing prices for the three sub periods are plotted. The study of these graphs provides an initial view of volatility for NSE Nifty stocks. It can be observed from the graph that the prefutures NSE Nifty stocks volatility is greater than that of post-futures. This broadly suggests that the introduction of index futures and options has not destabilized the spot market. However, inferences cannot be drawn from these figures alone, as they are not supported by any statistical data.
Following are the list of 15 companies :
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
ACC BHEL BPCL CIPLA GRASIM HDFC HDFC BANK HERO HONDA INFOSYS ITC MAHINDRA & MAHINDRA RANBAXY RELIANCE STATE BANK OF INDIA TATA POWER
NIFTY INDEX STOCKS :
COMPANY NAME ACC BHEL BPCL CIPLA GRASIM HDFC HDFC BANK HERO HONDA INFOSYS ITC MAHINDRA MAHINDRA RANBAXY RELIANCE STATE INDIA TATA POWER 0.501 BANK 1.08 0.788 OF 0.8 PRE 0.855 0.753 0.548 0.519 0.497 0.378 0.603 -0.13 1.18 0.834 & 0.707
BETA TRANSITION 0.972 0.802 0.548 0.655 0.74 0.213 0.458 -0.28 1.25 -0.04 0.887 POST 0.553 0.879 0.51 0.603 0.57 0.201 0.366 0.416 0.657 0.112 0.78
0.673 0.768 0.67
0.651 0.745 0.484
0.837
0.567
t-Test: Paired Two Sample for Means
Pre Mean Variance Observations Pearson Correlation Hypothesized Mean Difference df t Stat P(T<=t) one-tail t Critical one-tail P(T<=t) two-tail t Critical two-tail 0.706466667 0.065555267 15 0.572322326 0 14 1.153011382 0.134106265 1.761310115 0.26821253 2.144786681
Transition 0.6102 0.154027171 15
Interpretation :
In this mean systematic risk has reduced during the pre derivative period to transition period. But it is not statistically significant. t-stat is less than ttabulated .hence in this case null hypothesis is accepted,that is , Introduction of Index Stocks Futures and Options has no impact on the systematic risk and volatility of Spot Market.
t-Test: Paired Two Sample for Means Transition Mean Variance Observations Pearson Correlation Hypothesized Mean Difference df t Stat P(T<=t) one-tail t Critical one-tail P(T<=t) two-tail t Critical two-tail 0.6102 0.154027171 15 0.672646145 0 14 1.789926762 0.047555156 1.761310115 0.095110312 2.144786681 Post 0.4726 0.0393424 15
Interpretation :
In this mean systematic risk has reduced during the transition period to post derivative period and the decline is more than the pre derivative period. In this t calculated is statistically significant. Hence, in this case alternate hypothesis is accepted ,that is, Introduction of Index Stocks Futures and Options has an impact on the systematic risk and volatility of Spot Market
Graphical Evidence : ACC : Daily Closing Prices
Pre Derivative Period
Transition period
Post Derivative Period
BPCL:
Daily Closing Prices
Transition Period
BHEL :
Transition Period
CIPLA :
Transition Period
GRASIM :
Transition Period
HDFC :
Transition Period
HDFC BANK :
Transition Period
HERO HONDA : Daily Closing Prices
Transition Period
INFOSYS :
Transition Period
ITC :
Transition Period
MAHINDRA AND MAHINDRA : Daily Closing Prices
Transition Period

RANBAXY :
Transition Period
RELIANCE :
Transition Period
SBI :
Transition Period
TATA POWER : Daily Closing Prices
Transition Period
COMPANY NAME STANDARD DEVIATION PRE TRANSITION F TEST
ACC BHEL BPCL CIPLA GRASIM HDFC HDFC BANK HERO HONDA INFOSYS ITC MAHINDRA MAHINDRA RANBAXY RELIANCE STATE INDIA TATA POWER BANK
465.6483 59.97112 67.1879 843.7992 117.681 994.395 72.118 227.184 3273.922 141.3941 & 105.3232
24.125 21.73572 24.69962 148.2886 36.90431 79.352 14.986 368.412 1846.106 73.481 48.887
371.66 7.616 7.4 32.38 10.17 156.92 23.13 2.62 3.14 3.7 4.64
255.74 81.316 OF 31.894
88.588 39.283 23.822
8.28 4.28 1.79
11.571
25.688
4.92
Interpretation:
If F-Test value is below 1.53 tabulated value = Significant If F-Test value is above 1.53 tabulated value = Non-significant
Average variation seems to reduce drastically.Out of the 15 pairs of tested observations ,all of them are highly significant from January 1999 to December 2001.Hence,in this case alternate hypothesis is accepted ,that is, Introduction of Index Stocks Futures and Options has an impact on the systematic risk and volatility of Spot Market.
COMPANY NAME STANDARD DEVIATION TRANSITION POST F TEST
ACC BHEL BPCL CIPLA GRASIM HDFC HDFC BANK HERO HONDA INFOSYS ITC MAHINDRA MAHINDRA RANBAXY RELIANCE STATE INDIA TATA POWER BANK
24.125 21.73572 24.69962 148.2886 36.90431 79.352 14.986 368.4121 1846.106 73.481 & 48.887
11.175 27.326 45.64962 104.4578 17.23614 133.257 15.875 51.42 530.873 36.26 12.4411
4.66 1.58 3.41 2.01 4.58 2.81 1.12 51.2 12.09 4.1 15.44
88.588 39.283 OF 23.822
134.124 22.495 31.0973
2.29 3.05 1.7
25.688
9.8768
6.76
Interpretation:
If F-Test value is below 1.53 tabulated value = Significant If F-Test value is above 1.53 tabulated value = Non-significant
The table above shows the standard deviation of 15 companies for transition and post derivative period. The F-Test is computed on the standard deviation .In the transition and post derivative period average variation has reduced .Out of 15 pairs of tested observations 14 are highly significant and 1 is not significant. If F-Test value is greater than the tabulated value alternate hypothesis is accepted which implies that the introduction of derivatives has an impact on the volatility of index stocks.
CONCLUSION
Conclusion :
A study of nifty stocks systematic risk as measured by the beta shows that the systematic risk has reduced after the introduction of derivatives. The change is statistically significant in the post derivative period. While a comparison of nifty stocks volatility as measured by standard deviation shows that the volatility of stocks after the introduction of derivatives has changed significantly .It is observed that in most of the stocks volatility has come down in the transition and post derivative period. The overall result is that there is a change in systematic risk and volatility of index stocks due to the introduction of derivatives.
BIBLIOGRAPHY
Bibliography :
Websites :
www.nseindia.com www.finance.yahoo.com www.investorpedia.com www.google.com
Reference Articles:
Impact of futures introduction on underlying index volatility: evidence from India - kotha kiran kumar. & chiranjit mukhopadhyay Behavior of stock market volatility after derivatives - golaka c nath Do futures and options trading increase stock market volatility? Dr. premalata shenbagaraman Effect of introduction of index futures on stock market volatility: The Indian Evidence - o.p. gupta

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Impact Of Futures And Options Trading On Nifty Stocks Systematic Risk & Volatility

Master of Business Administration

Under the Guidance and Supervision Of

M.P.BIRLA INSTITUTE OF MANAGEMENT

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Derivatives are used by :

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Derivatives market in India:

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Derivatives market at NSE :

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Survey Of The Empirical Literature :

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Controlling Other Factors:

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Marginal Volatility Comparison :

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BEHAVIOUR OF STOCK MARKET VOLATILITY AFTER DERIVATIVES

Golaka C Nath Introduction :

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Data And Data Characteristics :

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Research Problem Statement :

Scope Of The Study :

Hypothesis Of The Study :

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Tools used for testing of hypothesis:

1) Beta 2) T- test 3) Standard Deviation 4) F -Test

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The test statistic is calculated as:

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(Standard Deviation 1)2 (Standard Deviation 2)2

Software Packages Used :

Limitations Of The Study:

2) Due to time constraint data of only few years could be taken.

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DATA ANALYSIS AND INTERPRETATION