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The purpose of this study is to investigate and test theoretical models that explain the volume-volatility relationship. Studying the volume-volatility relationship is important as it provides more insights into the structure of the financial markets, which has implications for the market participants (Nguyen and Daigler, 2006). Empirical evidence suggests that information that arrives in the market affects both volume and price volatility simultaneously. For example, Schwert (1989), Gallant et al. (1992), and Daigler and Wiley (1999) find support for the contemporaneous positive relationship between volume and volatility. We can classify models into two categories, which explain the volume-volatility relationship: (1) Information theories associate information with the volume and volatility, and (2) Dispersion of belief theories argue that traders have heterogeneous beliefs about the information and act accordingly, which in turn affects volume and volatility in the market.
In this study, we test both information-based theories and dispersed belief models by using tick-by-tick data for the five commodity futures (crude oil, gold, silver, copper, and zinc) traded at Multi-Commodity Exchange India Ltd. (MCX) for the period January 1, 2009 to December 31, 2012. The use of tick-by-tick data allows us to gain more insights into the trading activities in these markets and to explain the volume-volatility relationship. We use trading number and order imbalance (as a proxy for the information variable in these markets) in order to test the theoretical models developed to explain volume-volatility dynamics.
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