Single-Stock Futures: Evidence from the Indian Securities Market

Umesh Kumar Yiuman Tse

January 2007

JEL classification codes: G11, G14 Keywords: Single-Stock Futures, Price Discovery, Information Share

0000000
Umesh Kumar is a PhD student at the University of Texas at San Antonio, and Yiuman Tse is a Professor of Finance at the University of Texas at San Antonio. We thank Paramita Bandyopadhyay and Yulin Shi for computational assistance. Please address all correspondence to Umesh Kumar, One UTSA Circle, Department of Finance, University of Texas at San Antonio, San Antonio, TX- 78249-1644. Phone: (210) 458-7392. Fax: (210) 458-6320. Email:umesh.kumar@utsa.edu.

Single-Stock Futures: Evidence from the Indian Securities Market

Abstract Although single-stock futures (SSFs) are useful multi-purpose stock derivatives, they have not received much attention in developed markets. We analyze SSFs in the Indian market to understand their contribution in price leadership. The findings indicate that trades in the stock market contribute more to price discovery than trades in the SSF market (72% and 28%, respectively), while quotes in the SSF market are more price innovative than quotes in the stock market (39% and 61%, respectively). Thus, stocks and their SSFs are mutually dependent in terms of price innovation and formation, and no market simply free-rides on another market. Even without a vigorous stock lending mechanism, retail participation has catapulted SSFs into a position to capture the dynamism and vibrancy of the market.

Single-Stock Futures: Evidence from the Indian Securities Market

1. Introduction Single-stock futures (SSFs) represent a significant development in stock-related derivatives. It is an academic as well as practical conundrum as to why SSFs, as a derivative product, have not gained widespread acceptance in most markets, particularly in developed markets. We analyze the Indian securities market for evidence about the role of SSFs and their effectiveness in terms of price information and transmission. SSFs traded on the National Stock Exchange of India (NSE) have grown substantially since their inception in 2001. Why have other markets struggled to generate interest among investors for SSFs? A stock futures contract provides a way to take advantage of arbitrage, speculative, and hedging opportunities, reducing trading pressures on the underlying markets. Without futures contracts on individual stocks, arbitrageurs and investors must trade in the underlying assets, or trade options and index products. The US typically has the most vibrant markets for stocks and derivative products. Passage of the Commodity Futures and Modernization Act of 2000 made SSFs legal in the US by repealing the Shad-Johnson Accord some 20 years after its inception. On November 8, 2002, two exchanges, OneChicago and the Nasdaq Liffe Market (NQLX), started SSF trading. Single-stock futures offer a cheap and flexible way to gain equity market exposure for a wide range of purposes, such as hedging, speculation, and financial engineering. Yet the development of SSFs has been unimpressive in the US, the largest and the most sophisticated securities market in the world. Nor has SSF trading fared well in exchanges of other countries that have launched SSFs.

3 Research so far has concentrated on developed and matured markets for an understanding of the reception of SSFs. We look at the Indian market, where we see remarkable progress in SSF trading. Since their launch in November 2001, SSFs have showed incredible progress, making the NSE, the most vibrant SSF market in the world. The Futures Industry Association (July/August 2006) reports the NSE as the 13th-largest derivatives exchange by volume, and the NSE has the largest trading volume in SSFs worldwide. Thus, it is the largest global exchange for single-stock futures. In 2004, the NSE traded more than 25 million SSF contracts. Euronext.liffe, the second-largest exchange for this product, was far behind, at 7.5 million contracts. Our research investigates the success of SSFs in the Indian market and analyzes price discovery mechanics. We examine the most comprehensive sample of stocks and stock futures available over 12 months (252 trading days). We examine SSF evolution and benefits, their failures and successes. We also examine the roles of regulatory forces and institutional trades in price discovery of SSFs and their underlying stocks. Our research makes several contributions to the literature on single-stock futures by relating their benefit and success through retail participation. We evaluate the contribution of timely regulatory initiatives in broadening the SSF market. We attempt to corroborate how the success of SSFs may alter the dynamics of price leadership and information share. There is some evidence that SSF trading improves market efficiency. Ang and Cheng (2005) find that SSFs have a stabilizing influence on a market. SSFs with lower trading costs and higher leverage provide better relief for arbitrageurs than for speculators. In a study of stock futures trading in Australia, Lee and Tong (1998)

4 conclude that SSF trading offers many benefits associated with derivatives trading without increasing volatility or instability in the market. An increase in volume in the underlying stock markets has made stock brokers less wary of losing market share and profits to the SSF market. The SSF market is both more cost-effective and more informationally efficient than the stock market in terms of transaction costs and price discovery. Our findings for the Indian stock market suggest that the trades in the stock market perform better in terms of price discovery and information share than do trades in the SSF market. This result is contrary to previous findings that derivatives account for more price discovery and price leadership. However, quotes on SSF market lead quotes from stock market in contributing to price discovery. As the SSF market attracts sophisticated investors, both individual and institutional, the SSF market leads in adding information about a stocks intrinsic value from quote postings, while the stock market disseminates that value to all market participants through trade transactions. As such, each market is mutually dependent in price innovation and formation and neither market free-rides on the other. More than 93% of the contracts traded in the SSF market are from single-contract trades. This indicates the dominant participation of retail investors in the SSF market. As retail investors are not well-informed investors, the price discovery function takes place in the underlying stock market despite higher trading volume in SSFs, which is 1.6 times that of stock trading. Examining the information content of institutional trades on the London Stock Exchange, Bozcuk and Lasfer (2005) find that the type of investors, the combination of the size of the trade, and investors resulting level of ownership are the

5 major determinants of price impact. Institutional and individual investors observe news or price movements in different ways, process such information differently, and thus trade accordingly. Because institutional investors are more sophisticated and have greater resources, they are in a better position to influence price discovery for a security. A price pressure hypothesis implies that institutional trades influence price formation in a market more than trades by individuals. However, in the SSF market in India, there are fewer institutional investor trades than the retail investor trades. One plausible reason for the success of SSFs on the NSE could be the absence of an efficient or active stock lending mechanism in the equity market. A competing hypothesis is that of the three markets the equity market, the stock lending market, and the SSF market, whichever two first appear would act as a hidden market for the third. In the case of India, the equity and SSF markets surfaced first, and so the SSF market may be seen as a supplement for the stock lending market. In the case of the US, the equity and the stock lending markets developed first, so together they act as a complement for the SSF market. This hypothesis further theorizes that even if the third market is introduced later on, it will not necessarily expand or develop, as the other two markets would continue to offer a hidden market. That may be the reason for lackluster response to SSFs in the US or other developed markets that have vibrant stock lending markets. Our general results are inconsistent with the view that derivatives markets (in our case, SSFs) accounts for more of an information share and are responsible for more price discovery in multi-market trading in the same underlying security. Overall, we believe that direct retail participation is a necessary ingredient for the development of a healthy SSF market. Our results indicate that institutional trading (or the lack of trading) has an

6 effect on price discovery, as the participation of institutional investors makes prices more informative. But for a successful SSF market, it is essential that stock and SSF markets are mutually dependent in price innovation and formation. The remainder of this study is organized as follows: in section 2, we discuss the development of SSF market, section 3 describes the data construction and methodology, section 4 contains the empirical results, and the final section concludes the paper.

2. Development of the Single-Stock Futures Market Single-stock futures can be used as a substitute for equities for investment or speculation, as a leveraging instrument for hedging or speculation, or as a tool for price discovery in underlying stocks. Because they do not cost much to trade, they have considerable appeal to retail investors as a way to manage their stock portfolios1. SSFs do have a downside, as their leverage can amplify any losses, and they do not provide shareholder rights. Stock and futures markets are linked by various arbitrage transactions and parity conditions, but SSFs may become doubly risky if not properly used. They are not appropriate for unsophisticated traders or investors. Formalized exchange trading of SSFs started in the late 1980s in Sweden, but they have only recently become legal in the U.S. Now, more than 20 exchanges offer SSF products worldwide, but, by most estimates, the volume of SSF trading remains at less than 1 % of total financial-derivatives trading. Even though they are sound and useful instruments, well regulated, offered by renowned exchanges, and provide flexible instruments to achieve cost-effective hedging and portfolio rebalancing, SSFs have 6666666
As the SSFs are linear pay-off products, even retail investors can estimate the proceeds based on their risk appetites.
1

7 shown sluggish growth in most exchanges. Consequently, the instrument has not altered the dynamics of equity investing.

2.1. SSF Market in the US Studies demonstrate that derivative products such as SSFs boost the trading volume in the underlying assets, enhance their liquidity, and make the whole market more efficient. The average daily turnover of SSFs in the U.S. is around 10,000 contracts. It constitutes only about 1 % of the market for futures linked to the Standard & Poor's 500 stock index. This size of turnover is insufficient for a critical level of liquidity that is essential to narrowing bid-ask spreads. Institutional investors and other sophisticated traders are showing enthusiasm in the SSF market recently, but the retails investors are wary and circumspect in dealing with single-stock futures. Commenting on this poor retail investors response, Jones and Brooks (2005) state that single-stock futures prices in the US often have little relation to the prices of underlying stocks. Their findings imply that many hedging or large speculative trades may be difficult to execute in the current SSF market. Perhaps, this situation makes institutional investors reluctant to utilize this medium. It is pertinent to understand whether the SSF market has anything to do with the bias shown by investors due to unfamiliarity of the products, or the long side of the stock market, or some other considerations. Stock options have limited-liability features making them preferable for hedging or providing potential investment profits. It is also important to know whether the challenges facing SSF market are due just to investors indifference or the result of some form of regulatory initiatives.

8 2.2. Market Design and Structure in India India has a modern securities market. 5,600 firms are listed on two major stock exchanges. The exchanges are electronic and they have a T+2 rolling settlement system. The National Stock Exchange (NSE) is the largest stock exchange in India. It is the 3rdlargest stock exchange in the world in terms of trades, after the NYSE and Nasdaq. Measured by the number of futures and options traded in 2004, NSE ranked as the 17thlargest derivatives exchange in the world, and the 10th-largest futures exchange. It contributes to almost all derivatives transactions in India. The value of equity derivatives trading is more than two times of the value of equity trading. The NSE has three market segments (Wholesale Debt Market (WDM) segment, Capital Market (Equity) segment, and Derivatives segment). The derivatives trading system provides fully-automated, screen-based trading for all kind of derivative products. It supports an anonymous order-driven market, which operates on a strict price time priority. Trading terminals of the derivative segment are available in more than 300 cities across the country, and trading can be accomplished by investors through the Internet. India introduced SSFs on November 9, 2001. Prior to June 2001, there was no trading of derivatives of any kind, and trading of equities was done on an accounting period settlement basis. Accounting-period trading was akin to weekly futures for the equities. However, in accounting period trading, trades deal with a physically deliverable asset (unlike stock or index futures, which are notional). The trades remain outstanding and are settled by actual deliveries on the settlement date. When SSFs were introduced, market participants were doubtful of their success of in India, because even the U.S. did not have SSF trading.

9 In India, retail investors are dominant in SSF trading, including the proprietary trading of small brokerage houses. The top ten member firms account for just 21 %, a sharp contrast to most mature markets where the top ten member firms might have more than 60 % of the total SSF trading2. Only a small segment of SSF trading is institutional, and of that small amount, almost all comes from foreign institutional investors, who use SSF trades to carry out their hedging and portfolio rebalancing activities. Despite new derivative trading in India, NSE conducted 35 times more trading in SSF contracts than did OneChicago in the first two months of 2005. This paper looks at plausible reasons for the success of SSFs in India. The practice of badla and accountingperiod trading has been credited to an extent for this success. This futures-like practice was eliminated just before the SSFs were introduced. Hence, familiarity with badla and accounting-period trading was transformed into a demand for SSFs, ensuring an enormously successful new product. Indian traders were not at all accustomed to the idea of trading a broad market index. Therefore, broad market (or stock) index futures got off to a much slower start, although lately it is beginning to catch up.

3. Data Construction and Methodology 3.1. Data Source This study employs data from high-frequency stocks and their SSFs, obtained from National Stock Exchange of India (NSE) for January 2004 through December 2004, a total of 252 trading days. All derivatives trading in India is overwhelmingly concentrated in the NSE. We choose only NSE trade data for stocks, since its stock market segment 9999999
NSE monthly derivates update (December 2004) reports that the top five members make 12 % valuewise contribution while the next five have 9 %.

10 contributes almost 2/3rd of total trading volume in India. The data are in two segments (trade data and snapshots of limit order books). The trade data contain the details of all trades that took place in the exchange for the stocks and SSFs. The snapshots of limit order book for stocks were taken at four different times during the day. In the case of SSFs, the snapshots of the limit order book were taken at five different times. The limit order book contains all limit orders coming to the NSE trading system (right to trade against them, without any obligation) and they are free options which anyone can exploit. The snapshots obtained are the pictures of the complete limit order book at a given point in time. The order book snapshots times for stocks are 11 A.M., 12 noon, 1 P.M., and 2 P.M. The order book snapshots times for SSFs are 11 A.M., 12 noon, 1 P.M., 2 P.M., and 3 P.M. The normal market operation time for stock and SSF markets in the NSE is synchronized, with trading starting at 9:55 A.M. and closing at 3:30 P.M. The exchange selects SSFs in a scientific manner from among the top 500 stocks in terms of average daily market capitalization and daily traded value from the previous six months. We restrict our attention to only those SSFs that have daily trading volume above 1,000 contracts. Based on this criterion, we initially selected 40 SSFs. These SSFs and their stocks are the most liquid and actively-traded securities on the NSE. While analyzing, we find that some firms merged, changed their name or split up, and sometimes their volume became too low. Therefore, we eliminated such SSFs from our sample. In some cases, we could not obtain the desired data series from the raw data, so we were forced to drop those SSFs from our final sample. The resulting sample for our study is comprised of 30 stocks and their SSFs. These 30 SSF contracts contribute almost 80-85% of total trading volume. Similarly, their stocks represent 85-90% of total stock

11 trading volume. These stocks are constituents of the primary index of the exchange (the S&P Nifty Index). Futures on the S&P Nifty Index are quite popular among portfolio investors as they provide a better hedging mechanism than others that are available. Our dataset is more comprehensive and larger than the datasets used in many previous studies. It covers almost all of the trading volume of both market segments. The integrity of the data is strong, since the data are obtained directly from the exchange.

3.2. Data Preparation and Analysis We create two series of data. The first series contains trade price data for stocks and SSFs. Similarly, the second series contains quote price data for stocks and SSFs. First, we deduce minute-by-minute trade price each trading day for the stocks and SSFs. It is calculated by filtering opening and closing price of each minute, and then calculating the average price for every minute from the opening and closing price. Second, to obtain quote price data series for the stocks and SSFs, we create minute-by-minute price from the picture of the limit order book by merging all snapshots on a daily basis. This data file conveys the picture of quotes available in the limit order book. Third, we filter the highest bid quote and lowest ask quote for every minute from snapshots data file. Fourth, we calculate the mid-quote every minute from the bid and ask quote. Thus, we obtain a minute-by-minute quote price data series on a daily basis for our sample stocks and SSFs. Fifth, we omit the outliers, if any, from trade and quotes, to avoid contamination of the data series. We thus obtain 2,429,656 and 1,648,650 minute-by-minute observations from the trade and quote files, respectively.

12 3.3. Understanding Regulatory Implications and Institutional Trading One of the main tasks of this paper is to develop an understanding of regulatory initiatives toward SSFs. We pay particular attention to July 2004, since there was regulatory intervention in that month. New regulations increased the exposure and position limits for Foreign Institutional Investors (FIIs) in derivative products. We scrutinize whether such regulatory changes facilitate SSF trading by impacting price discovery activities. Institutional investors, including FIIs, were allowed to trade in SSFs in 2002, but there was a restrictive burden in terms of limits to position and open interest. In July 2004, the capital market regulator eased some restrictions on FIIs for position limits on derivative products. This also included doubling the market-wide position limit for SSFs. Since SSFs are part of the stock index, the relaxation of restrictions on FIIs to trade in futures of stock indexes affects price formation and discovery.

3.4. Price Discovery and Information Share between the SSFs and underlying Stocks One implicit assumption in the studies of price discovery is that markets share at least one common driving force and, therefore, common-factor models are employed in such studies. These models derive their results from the same economic rationales. To investigate price discovery and information share between stocks and SSFs, we use two popular common factor models, from Hasbrouck (1995) and Gonzalo and Granger (1995). Baillie, Booth, Tse, and Zabotina (2002), De Jong (2002), and Lehmann (2002) establish the relationship between the two models. Harris, McInish, and Wood (2002) and Hasbrouck (2002) enumerate the differences between the two models. Booth, Lin, Martikainen, and Tse (2002) use both models to examine the Finnish upstairs and

13 downstairs stock markets. A number of other studies have also used the informationshare and/or permanent-transitory models (see Tse & Erenburg, 2003, and the references therein). Both models use the vector error correction model (VECM) as their basis, but they differ in their price discovery mechanisms. The Hasbrouck (1995) model defines price discovery in terms of variance of the innovations to the common factor, and measures each markets relative contribution to this variance. This contribution is called the markets information share. The Gonzalo and Granger (1995) model, however, focus on the error correction process and the components of the common factor. This process involves only permanent (as opposed to transitory) shocks that result in a disequilibrium. The Gonzalo and Granger model measures each markets contribution to the common factor, where contribution is defined as a function of the markets error correction coefficients. The feature that distinguishes the models from each other is that the Hasbrouck (1995) model decomposes variance of the implicit efficient price. Relying on the premise that price volatility reflects the flow of information, it attributes a greater share of efficient price discovery to the market that contributes the greatest share to this volatility. In contrast, the Gonzalo and Granger (1995) model approach decomposes the common factor itself. In doing so, the Gonzalo and Granger model ignores the correlation among the markets and attributes the leading role solely to the market that adjusts least to the price movements in other markets. In markets affected by the same information flow (i.e. with similar volatility), these two models produce consistent results, i.e. a market with the greatest contribution to the price discovery has the largest loading on common factor.

14 Both information-share and permanent-transitory models are derived from a vector error correction model (VECM) in the following form: Xt = Xt-1 +

i X
i=1

t-i+

(1)

where Xt = {Xit} is an n x 1 vector of cointegrated prices. and s are n x n matrices of parameters, and t is an n x 1 vector of serially uncorrelated residuals with a covariancecovariance matrix = {ij}. The long run relation matrix has a reduced rank of r< n and can be decomposed as = , where and are n x r matrices. The matrix consists of the cointegrating vectors and is the error correction (or equilibrium adjustment) matrix. If r= n-1 and is spanned by the differentials of each pair of price series, then all xit are driven by one common factor. This is the case for stock and stock futures prices. Hasbrouck (1995) transforms the VECM into an integrated form of a vector moving average (VMA): Xt = J(

) + *(L)
=1

(2)

where J(1,..,1) is a column vector of ones, = (1,.., n) is a row vector, and * is a matrix of polynomials in the lag operator, L. The Hasbrouck(1995) model defines a markets contribution to price discovery as its information sharethe markets proportion of the variance of the efficient price innovation. By contrast, the Gonzalo and Granger (1995) model decomposes the common factor into a linear combination of the prices. An advantage of the Gonzalo and Granger model is that the common factor estimates are exactly identified, as they do not depend on the ordering of the variables.

15 Baillie et al. (2002) and De Jong (2002) show that the information-share and permanent-transitory models provide similar results, if the contemporaneous crossequation residuals are uncorrelated. If there is a strong correlation among the contemporaneous cross-equation residuals, differences in the results from the two models can be substantial. Hasbrouck (1995) points out that the information share estimates will depend on the ordering of variables in the Cholesky factorization, if the price innovations are correlated. Martens, Kofman, and Vorst (1998), Baillie et al. (2002), Booth et al. (2002), and Huang (2002) also report a substantial difference in their Hasbrouck upper and lower bounds of information shares. For a bivariate case, Baillie et al. (2002) provide various analytical examples to show that the average of the information shares given by two permutations is a reasonable estimate of a markets role in price discovery. We use average information shares to interpret the results.

4. Empirical Results 4.1. Relationship between the Stock and SSF Markets Figure 1 illustrates monthly trading turnover of all sample stocks and SSFs. We find that the turnover of SSFs is higher than the turnover of stocks, except in the months of May and June, 2004. This may be attributed to political instability caused by the general election in the country at that time. The general election and the delay in formation of the Federal Government contributed to lowering of trading volume. Overall, we find that SSFs have substantial trading, almost 1.6 times the number of trades of stocks. Trading volume is highest for both stocks and SSFs in January, 2004. Trading volume gradually

16 [Insert Figure 1 here]

slows down in subsequent months, and reaches its lowest in June, 2004. Later, trading volume gains in both segments.

4.2. Trade Size in the SSF Market First, we calculate average number of monthly trades, number of contracts per trade, percentage of trades, and percentage of volume in the SSF market. We try to understand the kind of investors dominating the SSF market. Table 1 exhibits our findings. It is important to note that we use executed contracts, not the underlying trade order or quote. We assume that SSF trading should be dominated by institutional investors (informed traders), since they are in better position to exploit the advantages offered by the SSF trading. We explore this assumption using size of trades transacted in the SSF market. [Insert Table 1 here]

We find that single contract trades overwhelmingly dominate the SSF market. On average, single contract trades account for more than 93% of all contracts traded. Two contract trades constitute only 4.35% of total trades, while trades in three or more contracts comprise only 2.47% of all trades. The notional value of a single contract size is comparatively small (4,500, in terms of USD). Trade size clearly indicates that institutional trades do not rule the SSF market. In this market, we assume that institutional investors would tend to deal in larger trade sizes, considering the transaction

17 and other attendant costs associated with doing single-contract transaction. The trading pattern above (i.e. overwhelmingly single contract trades) is consistent in almost all months. Therefore, we believe that there is strong retail participation in the SSF market, as claimed by the exchange and other market intermediaries3. The fact that retail investors (uninformed traders) are dominant traders in a healthy SSF market is unique.

4.3. Bid-Ask Spreads Table 2 presents the percentage spread for stock and SSF quotes. Percentage spread is measured as 100% x (Ask Price - Bid Price)/Midquote, where midquote is the average of bid and ask prices. We find that the mean percentage spread of stock quotes ranges between 1.19 % and 2.60 %. SSF quotes show mean percentage spreads between 1.49 % and 3.51 %. The difference between stock and SSF quotes varies between 0.11 % and 1.08 %. Overall, the mean percentage spread for stock quotes is 34% higher than SSF quote spreads, while volatility in stock quotes is 21% lower than the volatility in SSF quotes. The difference between the average mean spread of stock and SSFs quotes is 0.56 %. [Insert Table 2 here]

Stock quotes show lower spreads than SSF quotes. It is important to note that there is a difference between quote setting behavior in stocks and SSFs. We assume that SSFs should have lower spreads. But when we analyze the trade size, we find that the SSF
3

17171717171717
NSE monthly derivatives update (December 2004) mentions that non-institutional investors contribute more than 95 % of total derivatives trading. FOW (Issue 403 dated December 01, 2004) reports that in the SSFs, the main participants are retail traders and proprietary trading by member firms, followed distantly by foreign institutional business, and domestic mutual funds. Bloomberg News (April 05, 2006) reports that retail investors account for 63 % of the total trading in stock futures.

18 trading is mostly driven and influenced by retail participation. Hence, the higher spread observed in SSF quotes is not surprising. The presence of institutional investors lowers the spread, since their trades have more informational contents. The result augments the evidence of higher retail participations in the SSF market. It is interesting to note that the spreads are wider in stock and SSF quotes during June and July 2004, when there is political turmoil in the country. The trading volume of the SSF market shrinks and becomes almost equal to that of the stock market. When SSF trading volume increases, the spread differences narrow.

4.4. Information and Price Discovery in the stock and SSF markets 4.4.1 Results from Trade Transactions Table 3 reports the price discovery result for trade prices of SSFs and their stocks at one-minute interval. Both models show that the stock market produces higher price discovery in all months except July and August, 2004. In these two months, each market contributes almost equally in price discovery and transmission. [Insert Table 3 here]

We notice that the average information shares for stocks and SSFs are 0.72 and 0.28, respectively. The findings suggest that information production and price discovery occur in the stock market. Despite higher turnover volume in the SSF market as shown in Figure 1, the contribution of SSFs to price discovery is modest. The Gonzalo and Granger model provides similar results; 0.74 (stocks) and 0.26 (SSFs). Thus, our result is in contrast with other findings showing futures market more efficient in price discovery.

19 However, we find that July and August show that both markets have almost equal role in price leadership. We consider two significant events in this period. First, there was a change in regulatory limitations for Foreign Institutional Investors (FIIs) trading in stock index futures. Second, in the case of SSFs, there was a relaxation in market-wide position limits. These two factors may influence price discovery and information share contribution. It is worth noting that FIIs are sophisticated investors and are primary players in institutional trades for derivative products, including SSFs, while domestic institutional investors are relatively dormant in derivative products, particularly in the SSFs. The relaxation of regulation in stock index futures also affects the 30 sample stocks, since they are constituents of the indexes. The FIIs benefit from increases in market-wide position limits. During our sample period, they average 60% of the total open interest in the SSFs4. Open interest is a measure of how much interest a particular product garners from investors. FIIs have a higher level of open position in the SSFs which demonstrates their level of interest. Chan and Lakonishok (1995) report that the estimates of the price impact of institutional trades are substantially higher when trades are evaluated not individually but in the broader context of a package. Frino, Walter, and West (2000) document that investors with better market-wide information are more likely to trade in stock index futures, and the lead of futures market strengthens significantly around macroeconomic news releases. Bozcuk and Lasfer (2005) find that the type of investors behind the trades and the combination of the size of the trades and the investors resulting level of ownership are major determinants of the price impact. 19191919191919
4

Data obtained from SEBIs Annual Report 2004-05.

20 In our case, FIIs are major shareholders in the sample stocks. These findings corroborate that, after the relaxation in position limits in July 2004, the increase in FIIs trading in the SSFs alters the information content in prices. The bulk of the trades in the NSE do not come from any innate complementary hedging function that the SSFs offer, or even from any competitive advantage they enjoy over the stock markets.

4.4.2 Results from Competitive Quotes Being a price leader or information producer does not necessarily mean that a market also provides the best quotes. It simply indicates that the market impounds information faster than the others. Moreover, SSFs may not trade at exactly the same price as their stocks, but they will trade at a price that is very close because of the wellknown cost-of-carry relationship. Table 4 reports price discovery and information share results for stock and SSF quotes. To understand the quality of quotes, it is important to understand the characteristics of the markets from which these quotes originate. It is an accepted notion that the price discovery inferred from quotes does not necessarily reflect the market where the informed trader trades. The NSE has a trading mechanism for stocks and SSFs that is based on anonymous order-driven markets operating strictly on a price-time priority. Still, price discovery inferred from the quotes does not necessarily reflect the concentration of informed traders. It is possible that a market receives the best quotes, with more informational content, but the quote may not result into a trade. Hence, there is separation between price leadership from quotes and that from trades. [Insert Table 4 here]

21

These results are different from those reported in Table 3 using trades. We find that stock and SSF quotes yield an average information share of 0.39 and 0.61, respectively, while common factor coefficients are 0.37 and 0.63, respectively. This result indicates that SSF quotes lead stock quotes in price discovery. While the SSF market contributes more to price discovery for quoted prices, we find that this dominance does not extend to the prices for executed trades. This result is contrary to the belief that a market leading in price production in executed trades would tend to lead in the quotes also. A plausible explanation behind such result may be the transaction costs. We know that transaction cost is an important factor in placing the quotes when there is no market maker. In the NSE, there is no designated market maker in the stock market. The transaction costs in the derivates market are significantly lower than those in the stock market. A lower transaction cost enables traders to post quotes even for unprofitable informed trades. However, such quotes may not necessarily result into a trade. Therefore, it is possible that the derivatives market may not lead in price production for the executed trades. While making careful observation of our results in Table 4, we note that the information share dramatically increases to 0.74 in September 2004 and continues to remain above 0.70 afterwards. The transaction cost increased from September 2004 in the stock and SSF markets are due to first-time imposition of Securities Transaction Tax. A higher level tax was placed on the trades in stock market. This increased the transaction costs for the stock market. Overall, we conclude from these results that the SSF market

22 attracts investors at all levels of sophistication, including individuals as well as institutional investors. While the SSF market may reveal a stocks intrinsic value through quote data, that information is disseminated to all market participants through the trade prices in the stock market. In this way, the two markets are mutually dependent upon each other for price formation. Neither market is a free rider on the other.

5. Conclusion Single-stock futures (SSF) are a puzzling derivative product. They are useful multipurpose products, but have not gained market share in developed countries. By contrast, SSFs have done well in the Indian securities market. Hence, we study the Indian SSF market to understand its characteristics and the price discovery process for SSFs and their underlying stocks. This paper provides useful insights into the success of SSFs in the Indian market. We find that the stock market performs better in terms of price discovery and information share for trades. This result is contrary to the evidence from other studies, where derivative products enjoy more price discovery and transmission leadership. However, we find that SSF quotes lead stock quotes in price discovery contribution. This means that SSF quotes are better and more informative than the stock quotes. The SSF market attracts sophisticated investors, both individuals and institutions. Quotes posted in the SSF market reveal a stocks intrinsic value, but this intrinsic value is disseminated to all market participants through trades in the stock market. This indicates mutual dependency in price formation between these markets.

23 The absence of an efficient or active stock lending mechanism in the Indian stock market seems to have influenced the SSF market. We argue that of the three markets the equity market, the stock lending market, and the SSF market- whichever two appear first would act as a covert market for the third market. In India, equity and SSF markets appeared first, therefore the SSF market has taken a stride for stock lending market. In developed countries, including the U.S., a vibrant stock lending market overshadows the perceived benefits of SSFs. Therefore, the SSF market has not received the kind of momentum it has received in India. Further, strong retail participation is imperative for the success of the SSF market. Therefore, it is essential that the SSF contract should be affordable to retail investors as evident in the Indian market. Retail investors participation attracts more informed traders, improving liquidity and subsequently generating more volume. Regulatory intervention is also a vital consideration in the expansion of the SSF market. Overall, our findings demonstrate that for a vibrant SSF market to exist, it needs to be inter-dependent with stock markets in terms of price discovery, innovation, and leadership. The interdependency between stock and SSF markets compliment each other, benefiting all market participants by providing liquidity, price integration, and price efficiency.

24 Appendix Contract specifications for single-stock futures in the NSE.

Contract Size

As specified by the exchange subject to minimum value of Rs. 0.2 million.

Tick Size Trading Cycle

Rs 0.05 A maximum of three month trading cycle the near month (one), the next month (two), and the far month (three). New contract is introduced on the next trading day following the expiry of near month contract.

Margins Expiration Day

Up-front initial margin on daily basis. Last Thursday of the expiry month or the preceding trading day, if the last Thursday is a holiday.

Price Band Settlement Day Settlement Daily Settlement Price Final Settlement Price

Operating range of 20% of the base price Last trading day. In cash on T+1 basis. Closing price of futures contract on the trading day. Closing value underlying security on the last trading day of the futures contract.

Source: www.nseindia.com

25 References
Ang, J. S., & Cheng, Y. (2005). Financial Innovations and Market Efficiency: The Case for Single Stock Futures. Journal of Applied Finance, 15(1), 38-51. Baillie, R.T., Booth, G.G., Tse, Y., & Zabotina, T. (2002). Price Discovery and Common Factor Models. Journal of Financial Markets, 5, 309-321. Booth, G.G., Lin, Ji-Chai., Martikainen, T., & Tse, Y. (2002). Trading and Pricing in Upstairs and Downstairs Stock Markets. The Review of Financial Studies, 15, 1111-1135. Bozcuk, A., & Lasfer, M. A. (2005). The Information Content of Institutional Trades on the London Stock Exchange. Journal of Financial and Quantitative Analysis, 40(3), 621-644. Chan, L. K. C., & Lakonishok, J. (1995). The Behavior of Stock Prices around Institutional Trades. The Journal of Finance, 50, 1147-1174. De Jong, F. (2002). Measures of Contributions to Price Discovery: A Comparison. Journal of Financial Markets, 5, 323-328. Frino, A., Walter, T., & West, A. (2000). The Lead-Lag Relationship between Equities and Stock Index Futures Markets around Information Releases. Journal of Futures Markets, 20, 467 487. Gonzalo, J., & Granger, C. (1995). Estimation of Common Long-Memory Components in Cointegrated Systems. Journal of Business & Economic Statistics, 13, 27-36. Harris, F.B., McInish, T. H., &. Wood, R. A. (2002). Security price adjustment across exchanges: An investigation of common factor components for Dow stocks. Journal of Financial Markets, 5, 277-308 Hasbrouck, J. (1995). One Security, Many Markets: Determining the Contributions to Price Discovery. The Journal of Finance, 50, 1175-1199.

26
Hasbrouck, J. (2002). Stalking the Efficient Price in Market Microstructure Specifications: An Overview. Journal of Financial Markets, 5, 329-336. Huang, R.D. (2002). The Quality of ECN and Nasdaq Market Makers Quotes. The Journal of Finance, 57, 1285-1319. Jones, T., & Brooks, R. (2005). An Analysis of Single Stock Futures Trading in the U.S. Financial Services Review 14(2), 85-95. Lee, C., & Tong, H.C. (1998). Stock Futures: The Effects of their Trading on the Underlying Stocks in Australia. Journal of Multinational Financial Management, 8(2-3), 285-301. Lehmann, B. N. (2002). Some Desiderata for the Measurement of Price Discovery across Markets. Journal of Financial Markets, 5, 259-276. Martens, M., Kofman, P., & Vorst, T.C.F. (1998). A threshold error-correction model for intraday futures and index returns. Journal of Applied Econometrics, 13, 245-263. Tse, Y., & Erenburg, G. (2003). Competition for Order Flow, Market Quality, and Price Discovery in the Nasdaq 100 Index Tracking Stock. The Journal of Financial Research, 26, 301-318.

27 Figure 1 Monthly Trading Turnover in Stock vis--vis SSF

We calculate monthly stock and SSF turnover. The straight line indicates the monthly stock turnover in the exchange. The dotted line signifies the SSF turnover in the exchange. The turnover is denoted in Indian currency in billion rupees.
Stock Turnover Future Turnover

Monthly Trading Volume of 30 Stock and Future Trading Volume (in Billion 1400.00 1200.00
Rupees )

1000.00 800.00 600.00 400.00 200.00 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Month

28 Table 1 Trade Size in SSF

We calculate trade sizes for all SSF transactions. We derive monthly contracts in the SSF market from daily trade data. The trade size is segmented into three parts i.e. one-contract trade, two-contract trade, and three-or-more contract trade. From monthly data, we compute the monthly average trade size in the SSFs.

Month

OneContract (000) 2,330 1,712 1,680 1,980 1,641 1,691 1,785 1,807 1,845 1,858 1,768 2,552 1,887

TwoContract (000) 113 68 319 132 113 100 110 115 118 117 113 168 132

Three-ormore Contract (000) 60 37 169 81 72 63 69 74 82 80 80 114 82

Total Contract (000) 2,503 1,818 2,168 2,193 1,827 1,855 1,965 1,997 2,046 2,055 1,962 2,835 2,102

% of one % of two % of three Contract Contract or more Contract 95.17% 96.22% 83.73% 93.44% 92.07% 94.19% 94.67% 94.35% 93.91% 93.91% 93.48% 93.05% 93.18% 3.23% 2.48% 11.89% 4.21% 3.94% 3.33% 3.38% 3.55% 3.85% 3.87% 4.05% 4.43% 4.35% 1.60% 1.30% 4.38% 2.35% 3.98% 2.48% 1.95% 2.10% 2.24% 2.21% 2.47% 2.52% 2.47%

Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Average

29 Table 2 Percentage Spread in Stock and SSF Quotes

The statistics consist of stock and SSF quote spread for the sample period. The sample data are segmented into two panels. The percentage spread is measured as 100%x(Ask-Bid)/Miquote, where the midquote is the average of the bid and ask prices. The stock and SSF quote spread is derived from their mean spread on a daily basis. We obtain percentage spread difference by subtracting percentage stock spread from the percentage SSF spread. The significance of percentage spread difference is tested from zero by t-tests. Panel A represents the percentage spread in stock and SSF quotes on a monthly basis, while Panel B represents the percentage spread in stock and SSF quotes for entire sample period.

Panel A
Monthly Percentage Spread of Stock and SSF Quotes Mean Standard Deviation Month N Stock SSF Difference Stock SSF Difference Jan-04 21 2.21 2.68 0.48 0.54 0.53 0.23 Feb-04 19 1.76 2.49 0.73 0.34 0.43 0.23 Mar-04 22 1.69 2.31 0.62 0.18 0.18 0.16 Apr-04 20 1.60 2.12 0.52 0.19 0.13 0.16 May-04 21 2.60 3.51 0.91 1.66 1.53 0.29 Jun-04 22 1.61 2.69 1.08 0.18 0.27 0.17 Jul-04 22 1.54 2.50 0.96 0.30 0.36 0.20 Aug-04 21 1.29 1.85 0.56 0.09 0.15 0.14 Sep-04 22 1.19 1.49 0.30 0.08 0.12 0.11 Oct-04 20 1.35 1.64 0.29 0.13 0.15 0.13 Nov-04 19 1.34 1.51 0.16 0.13 0.15 0.12 Dec-04 23 1.40 1.51 0.11 0.10 0.16 0.16 Stock
18.88 22.84 44.28 38.65 7.18 41.41 24.46 66.82 66.92 48.11 45.72 68.71

t value SSF Difference

23.44 24.99 60.45 72.25 10.50 47.16 32.44 55.33 58.77 47.52 43.24 46.55 9.69 13.84 18.13 14.93 14.60 29.27 23.07 17.77 12.84 9.80 5.87 3.36

Panel B
Mean Percentage Spread of Stock and SSF Quotes Standard Variable N Mean Deviation Stock 252 1.63 0.65 SSF 252 2.19 0.82 Difference 252 0.56 0.35 Standard Error 0.04 0.05 0.02 t value 39.80 44.49 25.29 P value <.0001 <.0001 <.0001

30 Table 3 Information Share from Trades

The table reports price discovery results based on the Hasbrouck (1995) model and the Gonzalo and Granger (1995) model for stock and SSF trades. The prices are calculated at one-minute interval. The information share is the proportion of variance in the implicit efficient price of stock that is attributable to innovations in that market. The panel represents the information share on a monthly basis, and then we compute average to get overall information share for entire period.

Month Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Average

Hasbrouck Information Share Stock SSF 0.79 0.21 0.77 0.23 0.78 0.22 0.72 0.29 0.66 0.34 0.80 0.20 0.50 0.50 0.49 0.51 0.81 0.19 0.76 0.24 0.78 0.22 0.76 0.24 0.72 0.28

Gonzalo-Granger Factor Weights Stock SSF 0.84 0.16 0.84 0.16 0.80 0.20 0.77 0.23 0.70 0.30 0.83 0.16 0.51 0.49 0.39 0.61 0.84 0.16 0.80 0.20 0.80 0.20 0.79 0.21 0.74 0.26

31 Table 4 Information Share from Quotes

The table reports price discovery result based on the Hasbrouck (1995) model and the Gonzalo and Granger (1995) model for stock and SSF quotes. The quotes are computed at one-minute interval. The panel represents the information share on a monthly basis, and then we compute average to get overall information share for entire period.

Month Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Average

Hasbrouck Information Share Stock SSF 0.44 0.56 0.39 0.62 0.41 0.59 0.41 0.60 0.56 0.44 0.48 0.52 0.46 0.54 0.39 0.62 0.26 0.74 0.29 0.71 0.29 0.71 0.29 0.71 0.39 0.61

Gonzalo-Granger Factor Weights Stock SSF 0.44 0.56 0.38 0.62 0.41 0.59 0.40 0.60 0.57 0.43 0.48 0.52 0.42 0.58 0.31 0.69 0.24 0.76 0.28 0.72 0.28 0.69 0.27 0.74 0.37 0.63