Derivative Trading and Structural Changes in Volatility K. N. Badhani 1 Harish Bisht 2 Ajay Kumar Chauhan 3 Abstract: It is believed that the derivatives contribute in efficient price discovery of underlying assets and reduce the volatility in their prices. This hypothesis has been tested by many researchers for Indian stock market and most of them conclude that the volatility of stock prices has come down after the introduction of derivative trading in the market. However, use of a dummy variable as additional regressor with GARCH specification of conditional volatility is not capable to isolate the effect of derivative trading from the impact of other market reforms on the volatility of stock prices. In this paper we identify the dates of structural breaks in volatility of twenty-one stocks using CUSUM estimator and compare these dates with the dates of introduction of derivative trading in respective stocks. We do not find any conclusive evidence suggesting that the introduction of derivative trading has caused a reduction in the volatility of the prices of underlying stocks. Key Words: Structural Changes, Volatility, CUSUM, Derivative Trading JEL Classification: C22, G12 1. Reader, DSB Campus, Kumaun University, Nainital-263002, Uttarakhand, E-Mail- [email protected]. Mobile- 919412908097. 2. Research Scholar, DSB Campus, Kumaun University, Nainital 3. Faculty, Finance Area, Apeejay Institute of Management, Dwarka, Delhi.
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Derivative Trading and Structural Changes in
VolatilityK. N. Badhani1
Harish Bisht2
Ajay Kumar Chauhan3
Abstract:It is believed that the derivatives contribute in efficient price discovery of
underlying assets and reduce the volatility in their prices. This hypothesis has been tested
by many researchers for Indian stock market and most of them conclude that the volatility
of stock prices has come down after the introduction of derivative trading in the market.
However, use of a dummy variable as additional regressor with GARCH specification of
conditional volatility is not capable to isolate the effect of derivative trading from the
impact of other market reforms on the volatility of stock prices. In this paper we identify
the dates of structural breaks in volatility of twenty-one stocks using CUSUM estimator
and compare these dates with the dates of introduction of derivative trading in respective
stocks. We do not find any conclusive evidence suggesting that the introduction of
derivative trading has caused a reduction in the volatility of the prices of underlying
RIL Yes Decreased Increased DecreasedSAIL NoSBIN Yes Decreased Increased IncreasedTata Power Yes Increased Increased DecreasedTata Moters NoTotal Yes= 13
No= 8Increased= 7Decreased=6
Increased= 8Decreased=5
Increased= 4Decreased= 9
17
4. Results and Discussion:The stock-options on ACC stock were introduced on July 02, 2001 but the trading
of stock-futures started on November 9, 2001, which has been used as the effective date
of introduction of derivative trading on this stock. A volatility break on this stock is
observed on March 5, 2002, which is within six months’ period from the date of
introduction of stock futures on ACC. Data presented in Panel: 1 of the Annexure show
that during the period following this break the volatility persistence has increased, while
the unconditional volatility and the rate of adjustment to news ( ) have decreased.
In Case of Ambuja Cement, no volatility break is detected around the date of
introduction of derivative trading.
A structural break is found in volatility of Bajaj Auto on August 13, 2001, which
is within the stipulated time period in proximity of the introduction of derivative trading
on this stock. The results presented in Panel: 3 of the Annexure show that the rate of
adjustment in volatility has increased while the volatility persistence and the measure of
unconditional volatility have decreased during the period following this break. However,
these changes in the volatility dynamics are not of permanent nature as another break in
volatility takes place after a period of about four years and the situation inverts. The
similar phenomenon is observed in other stocks also.
The trading of stock-futures started in BHEL stock on November 9, 2001 and we
detect a structural break in volatility of returns on this stock on March 07, 2002. The
result shows that the unconditional volatility has decreased but its persistence as well as
the rate of adjustment towards new information has increased after this structural break.
In BPCL a structural break in volatility is observed on the April 19, 2001. During
the period subsequent to this break the volatility persistence and unconditional volatility
come down but the rate of adjustment increases (Panel: 5). Similar results are obtained
for Cipla (Panel: 6). However, no structural break is fond in proximity of the introduction
of derivatives trading on Dr. Reddy’s Lab (Pane: 7), Glexo (Panel: 8) and HPCL (Panel:
10).
Panel: 9 presents the results of the analysis of volatility breaks in Grasim. The
trading of futures started on this stock on November 9, 2001 and a structural break is
detected in volatility of the stock price on December 31, 2001. The results show that the
18
rate of adjustment towards new information has decreased and unconditional volatility
and the total persistence have increased after the introduction of derivative trading. These
results are just opposite of the observations that we had made in case of BPCL and Bajaj
Auto.
In case of HUL (previously, HLL), we observe that a structural break in volatility
takes place on October, 2001 (Panel: 11). During the period subsequent to this break the
persistence of the volatility increases; while, the adjustment coefficient and unconditional
volatility decrease. On the other hand we observe just opposite impact of derivative
trading on the volatility of L&T stock (Panel: 12), where the persistence of the volatility
decreases; while, the adjustment coefficient and unconditional volatility increases during
the period subsequent to the introduction of derivative trading.
The results of analysis of the volatility breaks in ITC stock are also similar to the
results of BPCL and Bajaj Auto. We observe an increased value of adjustment
coefficient, , and reduction in the volatility persistence and the unconditional volatility
of this stock for the period subsequent to introduction of derivative trading (Panel: 12).
On the other hand, the stocks of L&T and Reliance Energy show just opposite results
(Panel: 13 and 16). The stocks of M&M (Panel: 14) and SAIL (Panel: 18) do not show
any structural break in proximity of the date of introduction of derivative trading. The
stocks of MTNL (Panel: 15) and Tata Motors (Table: 20) do not show any structural
break in volatility at all during the period covered in this study. Stock of RIL, alike to
ITC, shows a decreased level of volatility persistence and unconditional volatility but an
increased level of adjustment coefficient after the introduction of derivative trading
(Panel: 17). In case of State Bank of India (SBI) the adjustment coefficient of the
volatility and unconditional volatility increase and persistence of volatility decreases after
the introduction of the derivative trading (Panel: 19); while in case of Tata Power (Panel:
21) the unconditional volatility decreases and the volatility persistence as well as the
speed of adjustment of volatility to new information increases.
The results obtained in this study show a mixed picture. Out of the 21 stocks, in
eight stocks no structural break was found within the stipulated time period. Out of
remaining thirteen stocks, which show structural break during the period in proximity of
introduction of derivative trading, the unconditional volatility has decreased in nine
19
stocks while in four stocks it has increased. The volatility persistence has increased in
seven stocks and decreased in six stocks. The rate of adjustment of volatility to new
information has increased in eight stocks, while it has decreased in five stocks. Therefore,
no generalisation can be made about the impact of derivative trading on volatility.
5. Conclusion:In this paper we have made an attempt to identify the structural breaks in the
volatility dynamics of twenty-one stocks using the cumulative-sum-of-squares (CUSUM)
procedure. These dates are compared with the date of introduction of derivative trading in
respective stocks to examine if any structural break is induced by the derivative trading.
If a break is observed in proximity of introduction of derivative trading, the nature of
changes in volatility persistence, rate of adjustment in volatility to news and
unconditional volatility have been analysed. We do not observe any consistent pattern in
the reaction of volatility dynamics towards introduction of derivative trading. Therefore,
it can be concluded on the basis of the results of this study that the introduction of
derivative trading has no definite implication for the volatility of underlying stocks.
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Annexure
1. Volatility Breaks in ACCDate of inclusion in Nifty : before 2002Date of commencement of derivative trading : 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 17-10-1996 2.6722 0.0798 0.7895 0.8692 20.434218-10-1996 to 05-03-2002 5.1401 0.1271 0.7897 0.9168 61.802406-03-2002 to 18-05-2004 2.1123 0.0779 0.8602 0.9381 34.113119-05-2004 to 27-02-2006 0.8276 0.0801 0.8768 0.9569 19.207428-02-2006 to 31-10-2007 3.0037 0.2937 0.5482 0.8419 18.9966
2. Volatility Breaks in Ambuja Cement
3. Volatility Breaks in Bajaj AutoDate of inclusion in Nifty : before 2002Date of commencement of derivative trading : 02-07-2001
4. Volatility Breaks in BHELDate of inclusion in Nifty : before 2002Date of commencement of derivative trading: 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 28-05-1998 3.5799 0.2556 0.5843 0.8399 22.365929-05-1998 to 07-03-2002 9.1327 0.1149 0.6721 0.7871 42.886408-03-2002 to 31-10-2007 2.0388 0.1575 0.7414 0.8989 20.1737
Date of inclusion in Nifty : before 2002Date of commencement of derivative trading : 20-04-2005
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 08-01-1998 1.3858 0.1022 0.8510 0.9621 36.563409-01-1998 to 07-05-2001 6.4163 0.1493 0.6133 0.7626 27.027308-05-2001 to 31-10-2007 1.4357 0.0964 0.8558 0.9522 30.0299
26
5. Volatility Breaks in BPCLDate of inclusion in Nifty : before 2002Date of commencement of derivative trading: 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- ) 02-01-1995 to 02-04-1998 3.2272 0.1593 0.4942 0.6535 9.3142 03-04-1998 to 19-04-2001 7.0561 0.1146 0.7911 0.9057 74.8180 20-04-2001 to 02-12-2004 5.0257 0.2000 0.5346 0.7346 18.9364 03-12-2004 to 31-10-2007 2.5205 0.0902 0.7976 0.8878 22.4667
6. Volatility Breaks in CiplaDate of inclusion in Nifty : Before 2002Date of commencement of derivative trading: 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 27-02-1996 5.1531 0.2368 0.50063 0.7375 19.627228-02-1996 to 18-12-1998 3.2377 0.2148 0.51033 0.7251 11.777319-12-1998 to 22-10-2001 3.7717 0.0726 0.89078 0.9634 103.024123-10-2001 to 25-04-2003 1.5358 0.1024 0.50407 0.6065 3.902926-04-2003 to 31-10-2007 3.0240 0.1547 0.55661 0.7113 10.4736
7. Volatility Breaks in Dr. Reddy
8. Volatility Breaks in GlaxoDate of inclusion in Nifty : Before 2002Date of commencement of derivative trading: : 01-07-2005
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 11-11-1997 2.8904 0.1777 0.1367 0.3143 4.215512-11-1997 to 17-12-1999 6.0813 0.2566 0.1054 0.3621 9.532617-12-1999 to 05-06-2000 12.0360 0.1773 0.2942 0.4715 22.771806-06-2000 to 21-05-2002 3.6969 0.2771 0.3878 0.6649 11.031422-05-2002 to 31-10-2007 1.5725 0.1276 0.7649 0.8925 14.6324
Date of inclusion in Nifty : Before 2002Date of commencement of derivative trading: 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 17-03-1998 2.1294 0.2210 0.6338 0.8548 14.664618-03-1998 to 21-06-2000 6.5563 0.1287 0.7772 0.9059 69.651722-06-2000 to 31-05-2004 5.1207 0.2005 0.0682 0.2687 7.001901-06-2004 to 31-10-2007 0.8829 0.0318 0.9574 0.9892 81.4470
27
9. Volatility Breaks in GrasimDate of inclusion in Nifty : Before 2002Date of commencement of derivative trading : 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 03-02-1998 2.0851 0.1144 0.3234 0.4378 3.708704-02-1998 to 26-05-2000 6.4494 0.0864 0.8591 0.9455 118.229427-05-2000 to 31-12-2001 5.9509 0.3074 0.2615 0.5690 13.806201-01-2002 to 31-10-2007 1.1593 0.1685 0.7733 0.9419 19.9402
10. Volatility Breaks in HPCLDate of inclusion in Nifty : Before 2002Date of commencement of derivative trading : 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 10-05-1995 6.1886 0.0111 0.8245 0.8356 37.643611-05-1995 to 29-05-1998 1.8622 0.1950 0.4607 0.6557 5.409030-05-1998 to12-01-2001 9.4250 0.3387 0.1072 0.4459 17.009613-01-2001 to 06-08-2002 1.9543 0.0891 0.8883 0.9774 86.513907-08-2002 to 31-10-2007 2.3208 0.1089 0.8484 0.9573 54.3013
11. Volatility Breaks in HULDate of inclusion in Nifty : Before 2002Date of commencement of derivative trading : 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 25-04-1997 0.9545 0.1520 0.6730 0.8250 5.452626-04-1997 to 10-10-2001 2.1280 0.1027 0.8372 0.9399 35.389711-10-2001 to 02-07-2003 0.9774 0.0991 0.8447 0.9437 17.366203-07-2003 to 31-10-2007 2.6968 0.1359 0.6235 0.7594 11.2087
12. Volatility Breaks in ITCDate of inclusion in Nifty : Before 2002Date of commencement of derivative trading : 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 02-11-2001 3.4298 0.0689 0.8795 0.9484 66.418103-11-2001 to 02-09-2005 1.6997 0.1810 0.6055 0.7865 7.961703-09-2005 to 31-10-2007 2.2541 0.0878 0.8126 0.9003 22.6129
28
13. Volatility Breaks in L&TDate of inclusion in Nifty : Before 2002Date of commencement of derivative trading : 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 30-04-1998 2.4064 0.1320 0.7277 0.8597 17.154501-05-1998 to 25-07-2000 7.3246 0.0824 0.8334 0.9159 87.052526-07-2000 to 09-11-2001 5.9836 0.1232 0.6126 0.7358 22.648010-11-2001 to 23-05-2003 0.7583 0.0186 0.9670 0.9856 52.659224-05-2003 to 31-10-2007 1.8871 0.1601 0.7634 0.9235 24.6802
14. Volatility Breaks in M&MDate of inclusion in Nifty : Before 2002Date of commencement of derivative trading : 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 14-01-1998 3.5084 0.1041 0.6018 0.7059 11.928715-01-1998 to 24-05-2002 6.0605 0.1324 0.7527 0.8851 52.736325-05-2002 to 31-10-2007 1.6448 0.0871 0.8717 0.9588 39.9231
15. Volatility Breaks in MTNLDate of inclusion in Nifty : Before 2002Date of commencement of derivative trading : 02-07-2001No structural break in volatility is detected
16. Volatility Breaks in Reliance EnergyDate of inclusion in Nifty : before 2002Date of commencement of derivative trading : 12-03-2004
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 01-04-1999 4.6660 0.1367 0.6092 0.7459 18.360802-04-1999 to 30-05-2001 6.3253 0.1646 0.6722 0.8368 38.764931-05-2001 to 06-06-2003 2.0174 0.1347 0.6117 0.7464 7.954707-06-2003 to 18-05-2004 5.9502 0.5140 0.0655 0.4485 10.790019-05-2004 to 31-10-2007 2.1141 0.2109 0.6901 0.9010 21.3477
29
17. Volatility Breaks in RILDate of inclusion in Nifty : before 2002Date of commencement of derivative trading : 29-11-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 20-11-2001 3.6022 0.2186 0.6355 0.8541 24.689621-11-2001 to 31-10-2007 2.1473 0.2527 0.4844 0.7371 8.1664
18. Volatility Breaks in SAILDate of inclusion in Nifty : 04-08-2003Date of commencement of derivative trading: 15-09-2006
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 24-11-1997 4.2023 0.2113 0.6260 0.8374 5.018625-11-1997 to 05-04-2000 20.2690 0.4358 0.0237 0.4595 35.500506-04-2000 to 09-07-2004 3.2230 0.2363 0.7418 0.9780 3.295510-07-2004 to 31-10-2007 3.1393 0.1815 0.7367 0.9182 3.4191
19. Volatility Breaks in SBIDate of inclusion in Nifty: Before 2002Date of commencement of derivative trading: 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 28-02-2002 0.8837 0.0667 0.8999 0.9666 26.425101-03-2002 to 19-12-2003 2.9875 0.1090 0.8261 0.9351 45.997020-12-2003 to 19-05-2004 6.0329 0.3889 0.2063 0.5952 14.902020-05-2004 to 31-10-2007 1.8995 0.0495 0.9143 0.9637 52.3412
20. Volatility Breaks in Tata MotersDate of inclusion in Nifty : before 2002Date of commencement of derivative trading : 26-12-2003No structural break in volatility is detected
21. Volatility Breaks in Tata PowerDate of inclusion in Nifty : before 2002Date of commencement of derivative trading : 02-07-2001
PeriodTotal
Persistence)
UnconditionalVolatility:
/(1- )02-01-1995 to 26-03-1999 4.1018 0.2074 0.1945 0.4019 6.857927-03-1999 to 04-03-20002 6.9024 0.1175 0.7107 0.8282 40.176905-03-2002 to 31-10-2007 1.4513 0.1572 0.7841 0.9413 24.7026