This paper examines whether the advent of future and option trading has led to an increase in index-stocks’ daily return covariation, systematic risk and volatility in the Indian stock market. A number of tests have been conducted on the S&P CNX Nifty Index, 25 index stocks and a control sample of 20 non-index stocks. The impact has been examined over the three sub-periods—pre, transition, and post derivative periods. The results seem to indicate that, in general, the S&P CNX Nifty and its component stocks have experienced a major structural shift in their systematic relationship with the market following the introduction of derivative products. Overall, the systematic risk has declined and the nature of volatility seems to have changed post derivative. The evidence finds that non-index stocks also do exhibit a similar pattern of decreased systematic risks and the changing nature of volatility structure during the same period. Thus, these impacts on the S&P CNX Nifty index and index stocks may not be due to derivative trading but due to secular changes in the general market forces which might have affected both index and non-index stocks simultaneously. The study provides evidence that the derivative trading increases the index stocks’ covariability. The opposite price behavior in the case of non-index stocks strongly suggests that the increased correlation among the S&P CNX Nifty stocks is associated with derivative trading activities and is not a result of a market-wide secular trend towards the higher correlation among the individual firm’s stock returns.

Derivatives, as the name implies, derive their value from the underlying securities/assets like stock, foreign exchanges, commodity, bond, etc. Hence, the introduction of derivatives products may affect the spot markets of the underlying assets. Many researchers have documented the impact on the spot markets with mixed results—derivative may increase or decrease volatility of the spot market; increase or decrease the systematic risks; and increase or decrease the return correlation among the index stocks. Many theories have been advanced explaining the contradictory conclusions. Martin and Senchack (1991) document a significant increase in the major market index’s and its 20 index stocks percentage systematic risk and covariability following the introduction of index futures and options in the US markets. They put forward two reasons—(1) Price Pressure Hypothesis, and (2) Cascade theory.

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