| This paper attempts an empirical examination
of effect of futures trading activity on the jump volatility
of the stock market by taking a case of NSE Nifty stock
index. Two alternative measures of the intensity of futures
trading activity employed are the monthly stock index futures
trading volume and the monthly open interest in the NSE
Nifty index futures contract. A span period of eight years
from June 2000 to May 2007 for monthly data is used. Using
the FPE/multivariate Granger causality modeling technique,
this study examines whether activities in the futures market
and other relevant factors have Granger-caused jump volatility
of stock prices. The macroeconomic variable used in the
study are volatility of the term structure of interest rates;
volatility of the NSE Junior index (proxy index with no
futures trading); volatility in the risk premium; volatility
of the inflation rate; and volatility of the industrial
production index. The study finds that futures trading activity
(measured in both trading volume and open interest) is not
a force behind the episodes of jump volatility. Moreover,
the volatility of other macroeconomic variables, such as
inflation and risk premium, are not responsible for the
volatility in stock prices of NSE Nifty.
There is a common belief that stock index futures are more
volatile than the underlying spot market because of their
operational and institutional properties. The close relationship
between the two markets makes the transference of volatility
possible from futures market to the underlying spot market.
It is, therefore, not surprising that the inception of future
contracts relating to the stock market has attracted the
attention of researchers all over the world and also led
some observers to attribute stock market volatility to futures
trading.
Two main bodies of theories about the relationship between
derivatives market and underlying spot markets exist in
the literature and both are contradictory to each other.
These theories are: (1) A `Destabilizing forces' hypothesis
that predicts increased volatility caused by more highly
levered and speculative participants; and (2) A `Market
completion' or `Non-destabilization' hypothesis, that says
futures market provides an additional route by which information
can be transmitted, and therefore, will reduce volatility
in spot. In other words, there are two opposing views regarding
the impact of these intermarket activities on the volatility
of cash prices. The stabilizing approach views that speculation
in the futures market results in decreased spot volatility
because future trading brings more informed traders to the
cash market, thus making it highly liquid resulting in decreased
volatility. On the other hand, the destabilizing approach
views that futures trading invites uniformed and irrational
speculative trading in both the futures and cash markets.
The impact that the derivatives market has on the underlying
spot market remains an issue debated again and again with
arguments both in favor and against them. All over the World,
many analysts and financial market observers have increased
their attention to stock price volatility and its deleterious
economic and financial effects, particularly since the market
crash of 1987 (Higins, 1988; Gertler and Hubbard, 1989;
and Becketti and Sellon, 1989). Stock exchange regulators
are constantly searching for new methods and procedures
to curb excessive market volatility. At this point, it is
pertinent to examine whether futures trading is actually
responsible for causing stock market volatility. Becketti
and Roberts (1990) found that these market regulations would
impose excessive costs on participants in the futures market.
In the last decade, many emerging and transition economies
have started introducing derivative contracts. Equity derivatives
trading started on June 9, 2000 with the introduction of
stock index futures by Bombay Stock Exchange (BSE). National
Stock Exchange (NSE) also commenced its trading on June
12, 2000 based on S&P Nifty. Trading on NIFTY futures
was introduced on July 12, 2000. Trading on stock futures
was introduced in the NSE on November 9, 2001. Subsequently,
other products like stock futures on individual securities,
index options, and options on individual securities were
introduced. The launch of derivative products has significantly
altered the movement of the share prices in the spot market.
Derivatives products are turning more and more popular day
by day. Nifty futures are scaling new heights and breaking
records daily, in terms of volumes and volatility. NSE in
India provides a fully automated screen-based trading system
for futures and spot market transactions on a nationwide-basis,
and on an online monitoring and surveillance mechanism.
It supports an order-driven market which provides complete
transparency of trading operations and operates on strict
price-time priority. S&P CNX Nifty is a well-diversified
50 stock index accounting for 24 sectors of the economy.
The base period selected for S&P CNX Nifty index is
the closing price on November 3, 1995. NSE Nifty stocks
represent about 59.49% of the total market capitalization
as on May 31, 2007. At any point of time, there are only
three contracts available for trading, with one month, two
months and three months to expiry. These contracts expire
on last Thursday of the expiry month and have a maximum
of three-month expiration cycle. A new contract is introduced
on the next trading day following the expiry of the near
month contract. All the derivatives contracts are presently
cash settled. S&P CNX Nifty futures contracts expire
on the last Thursday of the expiry month. If the last Thursday
is a trading holiday, the contacts shall expire on the previous
trading day.
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