Linkage between Stock Market Volatility and the Introduction of Index Futures in India M P Birla Institute of Management 1 Linkage between Stock Market Volatility and the Introduction of Index Futures in India A DISSERTATION SUBMITTED IN PARTIAL FULFILLMENT OFTHE REQUIREMENTS FOR THE AWARD OF MBA DEGREE OFBANGALORE UNIVERSITY. Submitted BySachna Sundar Reg.No-03XQCM6086 UNDER THE GUIDANCE OFSri. T.V.N. Rao INTERNAL GUIDE M.P.BIRLA INSTITUTE OF MANAGEMENT ASSOCIATE BHARTIYA VIDYA BHAVAN. BANGALORE-560001 2003-2004
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Linkage Between Stock Market Volatility & Derivatves
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8/7/2019 Linkage Between Stock Market Volatility & Derivatves
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 3
Background of Indian Financial Markets:
Financial markets in India have been largely synonymous with the Stock
markets. There were several reasons for this. Being a largely agrarian based
economy, the farming community was a completely protected one and the socialistic
policies followed by successive governments led to the image that trading in
commodities was something that was almost “un-Indian”. Therefore, commodity-
trading exchanges were never ever encouraged.
To this day, the vast majority of the trading taking place in the different
commodity markets in the country is all dominated by forward contracts between
actual producers and wholesalers/exporters etc. Further, the Indian economy being
a closed one, foreign exchange trading was something entirely, well, foreign. We
also had some kind of protectionism in the Gold and Silver markets and there was a
ban, until recently, on any kind of export or import of these metals. Therefore, this
market too could not develop like their counterparts in the other parts of the world.
This left only the Stock Markets as an arena where man could express one of his
natural instincts to trade. The rapid industrialization and the continued socialistic
policies of the seventies led to the FERA dilution which was the major impetus to this
market, led to greatly increased public interest in the markets. The era of the IPO
(initial public offering) was born and the stock market became the place for
investment.
As the markets grew, slowly, a need for some kind of a hedging mechanism
was felt by the players of the stock markets, now that the game had gotten a lotbigger than it ever was. The BSE Index during this period had risen from the sedate
200-300 ranges of the early eighties to 4500 in the mid nineties. This was a huge
rise and the decline that set in from there was also much, much larger than what had
been experienced by the players until then. By then the Mutual Fund industry had
also got established in the Indian markets.
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Development of exchange-traded derivatives:
Derivatives have probably been around for as long as people have been
trading with one another. Forward contracting dates back at least to the 12th centuryand may well have been around before then. Merchants entered into contracts with
one another for future delivery of specified amount of commodities at specified price.
A primary motivation for pre-arranging a buyer or seller for a stock of commodities in
early forward contracts was to lessen the possibility that large swings would inhibit
marketing the commodity after a harvest.
Introduction to Index:
An Index is used to summarize the price movements of a unique set of goods
in the financial, commodity, forex or any other market place. Financial indices are
created to measure price movements of stocks, bonds, T-bills and other type of
financial securities. More specifically, a stock index is created to provide investors
with the information regarding the average share price in the stock market. Broad
indices are expected to capture the overall behavior of equity market and need torepresent the return obtained by typical portfolios in the country.
• The primary function of a stock index is to serve as a barometer of the equity
market. The ups and downs in the index represent the movement of the
equity market. Any investor can look at the performance of the index to find
out how the equity market is doing.
• The availability of an index lends itself to forecasting of the market conditions
by technical analyst. Technical analysts believe that historical share price
movements can be used to predict the future price movements. They use the
stock index data to forecast which direction the market is likely to move in
near future.
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Linkage between Stock Market Volatility and the Introduction of Index Futures in India
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underlying individual security should be in multiples of 100 and fractions, if any,
should be rounded of to the next higher multiple of 100. This requirement of SEBI
coupled with the requirement of minimum contract size forms the basis of arriving at
the lot size of a contract
For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the
minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands
to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.
SEBI Amendment to Stipulations on Lot Size:
While the Legislative body stipulated the minimum contract size in terms of
value (Rs.2 Lacs), the system of standardising securities trade in Lots, had a
multiplying effect, on the minimum value of a contract, when the prices of the
premium Scrips started appreciating over time. BSE Index (Sensex) which was less
than 3000 at that time swelled to nearly 6500 presently. As the value of individual
scrips increased, smaller number of such scrips would be sufficient to cover the
minimum contract value of Rs.2.00 Lacs prescribed by the Standing Committee of
the Parliament. But stipulating a fixed number of shares as the lot in many cases
swelled the value of the contract to Rs.5 Lacs and even more in many cases. This
brought derivatives trading beyond the scope of the small investor.
Considering the fact SEBI revised its stipulations regarding Lot size, but
retaining the minimum contract value at Rs.2 Lacs and issued a press release on
07.01.2004 stating:
“It has been noticed that in several derivative contracts the value hasexceeded Rs.2 lakh. In such cases it has been decided to reduce the value of the
contract to close to but not less than Rs.2 lakh by using an appropriate lot size /
multiplier which could be half or 50%. The exchanges could determine any other lot
size / multipliers to keep the contract size of derivatives close to Rs.2 lakh, but in any
case not less than Rs.2 lakh. The exchanges would be able to reduce the contract
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Linkage between Stock Market Volatility and the Introduction of Index Futures in India
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AN INTRODUCTION TO FUTURES
For a trade to take place, what you need is two people- one with some goods
to sell and the other to buy it. The process of the trade will consist of both theseparties expressing their individual interests- one to buy and the other to sell – and
then they get into an auction process so as to decide the price. Once there is an
agreement on the price, the two shake hands and a transaction is complete. Where
multiple buyers and sellers congregate and multiple trades begin to occur, is called a
market. There are two ways that a trade can take place. One, the goods are
physically exchanged for money (like in a retail shop) or two; there could be a
transaction in a “promise” to deliver the goods at a future point of time for a price
agreed upon in the present.
This kind of transaction was the norm where the goods were expected to
arrive or be ready for shipment after a while – such as in Crops or commodities that
were imported or exported from other lands. The people dealing in such items would
be either the producer of it or a consumer of it. For example, a wheat farmer would
be quite interested in ensuring that he gets a good price for his crop – when he is
ready with it – from the bread manufacturer (who is the consumer of his product).
In the same fashion, the bread manufacturer is equally interested in tying up
good and consistent supply of wheat so that he can produce his goods (i.e. bread)
uninterrupted. This need of both parties is met by the formation of the “Forward
Market” or a market that deals in the present for value to be settled at some point of
time in the future.
Such Forward markets have existed ever since trade began. They had some
imperfections within them and this led the traders to form what came to be known
subsequently as the Futures markets.
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Linkage between Stock Market Volatility and the Introduction of Index Futures in India
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Economic Relevance of Futures Markets:
The most important role that the futures markets perform is in aiding the
process of proper price discovery. Since several different types of players areengaged in trading the futures markets with different intentions, it leads to a correct
pricing of the asset. This has important fall out, especially in the commodity and
currency markets. It prevents incorrect extension of trends that would be harmful to
the general public and thereby leads to greater market efficiency.
The presence of a larger number of tradable instruments also leads to a more
complete market, one where every type of player can have the maximum number of
features which will permit him to participate to the fullest extent in the markets. The
proper design of the futures products and the framework of trading help to contain
the risks in investments for different players. This leads to a more reliable and longer
lasting system.
Factors Driving the Growth of Financial Derivatives:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international
markets,
3. Marked improvement in communication facilities and sharp decline in their
costs,
4. Development of more sophisticated risk management tools, providing
economic agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets leading to higher returns,
reduced risk as well as transactions costs as compared to individual financial
assets.
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Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 22
Summary:
The advent of the futures markets in India is a welcome addition to the
number of instruments that is currently available to the individual trader and investoras well as the institutional players. One need no longer bemoan the lack of hedging
facilities in the market and this is one of the most bullish developments for the long
term. The Indian stock markets can now begin attracting entirely newer set of
players who were hitherto hesitant to enter the stock markets because of the
absence of risk containing measures. The world over, the experience has been that
the cash market has multiplied several fold with the introduction of the Futures
markets, particularly, options. The same may be expected to happen in India too.
We are therefore set for very exciting times ahead of us in the markets. The entire
face of the stock markets as we knew it is set to change. Truly, we are now about to
catch up with the rest of the world.
Due to the introduction of index futures, the stock market volatility gets
affected. This is an attempt to study the impact of allowing the index futures trading
on the stock market by using one of the measures of volatility. The method is based
on close-to-close price, to measure volatility. This also attempts to find out how the
futures market volatility affects the underlying stock market volatility. The stock
market gets more matured, and the volatility in the stock market gets reduced to a
considerable extent by the introduction of index futures in India.
The Indian capital market has witnessed a major transformation and structural
change during the past one decade, as a result of the ongoing financial sector
reforms since 1991, in the wake of policies of liberalization and globalization. The
major objectives of these reforms have been to improve the market efficiency,
enhance transparency, check unfair trade practices, and bring the Indian market up
to international standards.
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Linkage between Stock Market Volatility and the Introduction of Index Futures in India
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METHODOLOGY:
The data employed in the study consists of daily prices of major stock market
index viz., the S&P CNX Nifty Index (henceforth Nifty Index) for a four and a halfyear period from June 8, 1998 to December 31, 2002.For this index, two sets of
prices were used. These were daily open and close.
Likewise, open and close prices were used for a period of one and a-half
year period i.e., from June 12, 2001 to December 31, 2002 for the Nifty Index
Futures contracts. The necessary data have been collected from the derivative
segments of this exchange.
The study has used measure of volatility.
In the first place, the daily returns based on closing prices were computed
using question:
Rt = ln (C t /C t-1)
Where,
C t and C t-1 are the closing prices on day t and t-1 respectively.
R t represents the return in relation to day t.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 31
presented and discussed. Here again, the results are discussed separately for the
futures and the index.
IMPACT OF INTRODUCTION OF INDEX FUTURES ON STOCK
MARKET VOLATILITY:
The research now present and discuss the empirical results pertaining to the
impact of introduction of index futures contracts on the stock market volatility in
respect of both the indices.
Effect of Introduction of Index Futures on Nifty Index:
Tables 1 show the effect of introduction of index futures contracts on Nifty
Index in respect of ln (Ct/Ct-1), for several periods. Interestingly, the volatility of the
market seems to have declined post introduction of index futures for all the periods,
in respect of both these measures. In fact, expecting for the one-month period, theresults indicate that post introduction volatility of the Nifty Index has declined.
Though, for the one-month period too, the volatility seems to have declined, but it
was not found to be statistically significant. One possible explanation could be that
the market operators took time to understand the intricacies of the operations of the
futures market.
This is clearly reflected by the low level of futures market’s activities, both in
terms of number of contracts and the volume of trades done in the month of June
2000.
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Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 33
RELATIVE VOLATILITY: INDEX FUTURES AND SPOT MARKETS:
The research shall now present and discuss the results of relative volatility of
futures and spot market in respect of both the indices, to see whether index futuresare more (less) volatile than the underlying spot index.
Daily Price Volatility: Nifty Index Futures and Nifty Index
Empirical results relating to relative volatility of Nifty Index futures and Nifty
Index Spot index are given in Tables3; Table gives the daily volatility for each monthfrom June 2001 to December 2002 for the near month Nifty Index Contracts, and for
the spot market on daily basis using the close-to-close volatility measure given by ln
(Ct/Ct-1).
In terms of the measure, though volatility of near month futures contracts is
higher in respect of 8 months out of 19 months, none of them, however, is
statistically significant. In fact, on comparison, volatility of futures and the spot
market does not seem to be different for any of the months studied. Similarly, for the
total period, the volatility for the markets is significantly different. Interestingly, here
volatility for the spot index was found to be higher in respect of 14 months out of 19
months. However, only in respect of three months viz., June 2001, November 2001
and August 2002, the spot index volatility was significantly higher than the near
month futures contracts.
However, for the overall period, the volatility for the market is not statistically
significant. .Here, too, the spot volatility was significantly higher than the near month
futures contracts for only for three months viz., June 2001,November 2001 and
August 2002.
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