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Stock price movements, along with volume and liquidity, play an important role in formulating
investment decisions. With the introduction of the financial derivatives in the Indian stock
market, the investor has access to more sophisticated instruments to base their investment
decisions. The Indian financial markets have a long history of operation, but the financial
derivatives market was developed in the late 1990s. Derivatives trading started in India in
June 2000 after Securities and Exchange Board of India (SEBI) granted the final approval on
the recommendation of L C Gupta Committee. In 1998, J R Varma Committee worked out
various operational details such as the margining systems. In 1999, the Securities Contracts
(Regulations) Act (SC(R) A) of 1956 was amended so that derivatives could be declared
‘securities’. Futures trading is available on the index as well as some of the individual stocks.
National Stock Exchange (NSE) accounts for over 95% of derivatives trading in India.
Presently, financial derivatives (futures and options) turnover overshadows the cash market
turnover by almost five times on a trading day. This shows the importance of the derivatives
market in the Indian financial market. It thus makes it even more important to analyze the
various relationships that may exist among some of the more relevant variables in the Indian
derivatives market. Such a study would help various market players in understanding the
Indian derivatives market better. We have thus decided to analyze the relationship that may
exist between Returns Volatility (RV), Open Interest (OI) and Volume (VOL).
Volume and open interest are secondary technical indicators in the futures market. Open
interest is an important parameter in the futures markets; it is the number of contracts outstanding at any point of time. As a new contract is introduced, the investors start
taking a view on the market of the underlying asset and take an exposure on the futures
contract. However, open interest is different from volume. Volume refers to the number of
contracts traded in a day. Cumulatively, it would always increase. Open interest would
increase by the number of new contracts opened in a day. The contracts that are offsetting
the initial position do not add to the open interest, but they do add to the volume. Volume
indicates intensity of trade taking place or simply market activity, while open interest
indicates depth or liquidity of the market. Open interest phenomenon is unique to the
futures market. Since volume and open interest are considered secondary indicators in
technical analysis to study the changes in price trends and predict reversals, it becomes
imperative to understand if both volume and open interest have explanatory powers to be
used as exogenous regressors in the conditional volatility equation to model the price
fluctuations or volatility in the index futures returns series. Further, following Bessembinder
and Seguin (1993), both trading volume and open interest are split into their expected and
unexpected components. The expected component indicates the average level of trading,
while the unexpected component indicates any surge in trading due to unexpected price
changes. An increase in volume and open interest would thus indicate an increase in
liquidity and improvement in price discovery with the possibility of lessening the impact
of volatility.
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