CHAPTER-2 LITERATURE REVIEW

Since the beginning of trading in financial futures and options in the 1970s, the effect of financial derivatives trading on the underlying spot markets has been of great interest to both academics and practitioners. One of the issues commonly investigated by finance researchers is whether futures trading increases the price volatility of underlying markets and thus leads to destabilisation of these markets. Previous studies provide mixed evidence on this issue. The relationship between currency future and trading volume has been examined frequently and usually is in a positive correlation between volatility and trading volume. Copeland (1976), develope sequential arrival of information models where new information flows into market to generate both trading volume and price movement. Some studies provide empirical results that support the opinion that trading in futures can destabilize the spot market. For example, Figlewiski (1980) investigates the futures contracts for Treasury Bills (GNMA pass through certificates) and provides evidence that futures market activity increases the volatility of cash prices. To investigating the market behaviours (such as currency price volatility, metal market depth and trading volume) is an important aspect of research on the market microstructure literature. Tauchen and Pitts (1983) argue that these three variables are closely related. However, most studies deal with mutual contemporaneous relationship between two of those three dimensions and reach no consistent results. Very few empirical papers

investigate the dynamic nature of the interactions, such as the feedback effects between those three variables. Karpoff (1987) identified relation between price changes and trading volume in financial markets. In those studies above, it is consistently positive contemporaneous relation between return volatility and trading volume but lacks consistent in the relation between return volatility and market depth or between market depth and trading volume. Furthermore, there are few studies for the analysis of return volatility and trading volume incorporating with the market depth, which is proven to be fundamentally related to trading activity and market behaviour of return volatility (Bessembinder and Seguin, 1992). Eighteen of nineteen empirical papers support the positive correlation between volatility and trading volume. Bessembinder and Segun (1993) accommodate persistence in the positive relationship on eight futures market by ARCH-GARCH empirical method. Antoniou and Holmes (1995) examined the impact of trading in the FTSE-100 index futures on the spot price volatility and concluded that futures trading improves the quality and speed of information flowing to spot markets. Their evidence suggests that there has been an increase in spot price daily volatility, but that this due to increased information in the market and not to speculators having adverse destabilizing effect. As suggested by Malliaris (1997), the origin of futures markets is related to the necessity to manage the risk associated with volatile spot price changes of certain assets. It can also be claimed that futures contracts became more popular since the

economic deregulation in 1970s, which resulted in increased volatility in foreign currencies, debt instruments and stock indexes. Market observers and regulators have generally acknowledged the crucial role that futures markets have in risk transfer and price discovery, but they have often expressed concern over the potential role that futures activity may have in destabilizing the markets. Taylor (1998) investigates precious metals (gold, platinum and silver) reactions against inflation. He tested the hypothesis that precious metals act as short-run and long-run hedges against inflation. He focused his analysis on the period before 1939 and around the second OPEC oil shock in 1979. During no other period could precious metals be used to hedge inflation. His analysis notices that the belief that precious metals (in particular gold) have always acted as hedges against inflation until very recently is completed unfounded. He found that there have been particular periods during the last 80 years when precious metals have been used as a short-run hedge against inflation, but they could not be used to hedge inflation around the first oil crisis in 1973/74 or during the last ten years. Since he found a co integrated relationship between metal prices and the level of CPI with the help of a VAR model, it can be inferred that precious metals can be used as a long-run inflation hedge. More recent study by Bae, Kwon and Park (2004) focused on the effect of the introduction of index futures trading in the Korean markets on spot price volatility. The authors concluded that introducing the futures and options trading on the Korean stock exchange resulted in both larger spot price volatility and greater market efficiency (allowing for quicker adjustment of market prices to information).