I.

INTRODUCTION

In future trading, there is usually a contract, which is essentially an agreement

between two parties to buy or sell an underlying asset at a certain time in the
future at a certain price. A future contract usually has a standardized date and
month of delivery, quantity and price.

Future trading is usually carried out on a future exchange. Future differs from
forwards in terms of margin and delivery requirements. In order to facilitate
liquidity in futures trading, the future exchange specifies certain standard
feature of the contract.

In future trading, a futures contract may be offset prior to maturity by entering

into an equal and opposite transaction. More than 99% of transactions in the
future trading are usually offset in this manner. The date specified in the
options/future contract is known as the expiration date.

The Future price is the price at which the future contract trades in the future
market. The expiration date for all contracts in future trading is usually the last
Thursday of the respective month. Three series of future contracts are available
and have one-month, two-month and three-month expiry cycles. On the Friday
following the last Thursday, a new contract having a three-month expiry is
introduced for trading.

The most important role that future trading performs is in aiding the process of
proper price discovery. Since several different types of players are engaged in
trading the future.

Apart from aiding price discovery, future contracts also aid in the
hedging of price risk in a commodity. Future contracts are useful for the
producer because he can get an idea of the price likely to prevail and thereby
help them quote a realistic price and hedge risk.

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 A large number of theoretical and empirical studies have examined the
effect of stock index future on the volatility of the underlying spot market.
Although the academic findings of these studies thus far have not produced
any conclusive evidence on this issue, the popular public perception seems to
be that index future trading will, increase the volatility in stock market.

Theoretically, the impact of stock index future on the stock market

volatility is still not clear. The linkage between these derivatives markets and
the stock market is generally established through arbitraging activities. The
results, however, depend, to a large extent, on what assumptions are made
about the arbitrageurs. The important assumption on whether index future’
trading brings in more informed or uninformed investors to the stock market.
One school of thought argues that arbitrating or speculating activities in the
future markets add more informed traders to the stock market, thereby
increasing the liquidity and decreasing the volatility of the market. The schools
of thought asserts that index future introduce more uninformed or irrational
traders in both the derivatives and stock markets in search of short-term gains,
therefore increasing the stock market volatility. Stein (1987) develops a model
and shows that future trading by poorly informed investors or speculators in
fact destabilizes the stock market and therefore increases its volatility. By
contrast, Danthine (1978) presents a model which implies that future markets
help improve market depth and reduce volatility, since the cost responding to
mispricing is reduced for informed traders. In another study, Weller and Yano
(1987) use a general equilibrium model to study the effect of stock index
future trading on the volatility of the stock market and conclude that stock
market volatility may decrease when index future are introduced.

In the middle of 1995, the Hong Kong Future Exchange introduced a

number of new future contracts amid substantial controversy and legal battles.
Similarly, new derivative products in Australia created much discussion, with
the Sydney Futures action over the introduction of new contracts. Settling the

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controversy has not generally been assisted by the inconsistency in the
research findings.

Two schools of thought have emerged to explain the impact of future

contracts on the underlying asset. One view is that the introduction of future
trading increases the price volatility. For example, the inflow and existence of
speculators in future markets may produce destabilizing forces, which among
other things create undesirable bubbles. ( e.g., Edwards, 1988a, 1988b; Harris,
1989; Stein, 1987, 1989). Furthermore, an increased in volatility on expiration
days is expected as investors attempt to close out their positions, settle
contracts, and trade o potential arbitrage opportunities. Generally, the financial
press appears supportive of these arguments wit claims that future have raised
volatility via the provision of low-cost speculation opportunities, especially in
the case of Japan.

The alternative argument is that the introduction of future contracts has

led to more complete markets, enhancing information flows and thereby
improving investment choices facing investors ( e.g., Arditti & Johan, 1980;
Breeden & Litzenberger, 1978; Hakansson, 1978; Ross, 1977). Future
contracts allow for new positions and expanded investment sets or enable
existing positions to be taken at lower costs. Future trading may bring more
(private) information to the market and allow for facilitate hedging so that less
reliance need be placed on spot hedging strategies. Moreover, the transfer of
speculative activity from the spot market to the future market may damp in
spot market volatility. Indeed, Schwert (1990) showed that intraday index
future volatility is around 40% higher than intraday equity market volatility.

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 i. PURPOSE/OBJECTIVE

The purpose of this study is to address whether the introduction of

single stock future on the Karachi Stock Exchange (KSE) has any impact on
the volatility and volume of the underlying stocks.

A large number of theoretical and empirical studies have examined the

effect of stock index future on the volatility of the underlying spot market.
Although the academic findings of these studies so far have not produced any
conclusive evidence on this issue, the popular public perception seems to be
that index future trading increases the volatility in stock market.

The objective of the study are:

1. To analyze the role of future trading on stock exchange.

2. To analyze the effect of future trading on stock price volatility.

ii. RESEARCH PROBLEM

The problem of this study is to address whether the introduction of

single stock future on the Karachi Stock Exchange (KSE) has any impact on
the volatility and volume of the underlying stocks.

A large number of theoretical and empirical studies have examined the

effect of stock index future on the volatility of the underlying spot market.
Although the academic findings of these studies thus far have not produced
any conclusive evidence on this issue, the popular public perception seems to
be that index future trading increases the volatility in stock market.

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iii. HYPOTHESIS

H  There is no significant difference in the stock returns volatility in

the prices of the underlying stocks during the sample period, before and after
the introduction of single stock future in the underlying stocks in Pakistan’s
stock market.

H 1 There is significant difference in the stock returns volatility in the

prices of the underlying stocks during the sample period, before and after the
introduction of single stock future in the underlying stocks in Pakistan’s stock
market.

iv. Scope of study

The scope of this study is to address that weather the introduction of

single stock future on Karachi stock exchange have any impact on the stock
price volatility of 29 stocks from different sector listed in the Karachi stock
exchange.

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II. REVIEW OF LITERATURE

Most empirical studies have examined the impact of index future by

comparing the unconditional variance of returns before and after the
introduction of future. The introduction of stock index future trading may lead
to a change in the speed of information flow to the stock market. To examine
the effects of future trading on spot market volatility, several studies (Antoniou
& Holmes, 1995; Antoniou, et al. 1998; Baldauf & Santoni, 1991; Lee & Ohk,
1992; Pericli & Koutmos, 1997) used a model that recognized the temporal
dependence of stock return volatility.

Baldauf and Santoni (1991) tested for the presence of Autoregressive

Conditional Heteroscedasticity (ARCH) effects in daily stock returns,
controlled for these effects by modeling them, and tested to check whether
model parameters shifted after the institution of program trading. They found
no evidence of a shift in the model parameters. Lee and Ohk (1992) examined
the effects of introducing index future trading on stock return volatility in
Australia, Hong Kong, Japan, the United Kingdom, and the United States of
America. They found that stock volatility increased significantly shortly after
the listing of the stock index future, with the exception of the stock markets in
Australia and Hong Kong. Using U.K. data, Antoniou and Holmes (1995)
modeled volatility as a GARCH process and found a significant increase in
cash market volatility after the introduction of the Financial Times Stock
Exchange (FTSE) 100 index in 1984. Pericli and Koutmos (1997), using an
exponential GARCH model, found that the volatility of the Standard & Poor’s
(S&P) 500 index decreased after the introduction of future trading. Antoniou et
al. (1998) examined the impact of future trading on the volatility of S&P 500
index with the asymmetric GARCH model proposed in Glosten, et al, (1993).
Their results suggest that the introduction of future has not had a detrimental
effect on the underlying spot market.

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 This study models the well known tendency of stock returns to exhibit
volatility clustering (i.e., conditional heteroskedasticity )by using the GARCH
model of Bollerslev (1986) and tests for changes in conditional volatility after
the introduction of derivatives. French, et al, (1987) and Akgiray (1989)
applied GARCH models stock indexes. Schwert and Seguin (1990) applied the
GARCH model to portfolios. Lamoureux and Lastrapes (1990) and Kim and
Kons (1994) applied the GARCH model to individual stocks.

Foster (1995) employed the GARCH model for investigating the

volume volatility relationship in the oil future markets. Kyriacou and Sarno
(1999) employed the GARCH model to construct a spot market volatility
proxy in empirically examining the dynamic relationship between derivatives
trading and spot market volatility with daily data for the FTSE index in the
United Kingdom. Hogan, Kroner and Sultan relationship between program
trading and volatility in the S&P 500 future market. Baillie and Bollerslev
(1990) examined intraday volatility in foreign exchange markets with a
seasonal GARCH model. Locke and Sayers (1993) employed the GARCH
model to examine the intraday variance structure of index future return series.
Andersen and Bollerslev (1997) examined the characteristics of intraday return
volatility in the foreign exchange market and index future markets with a
GARCH specification.

Froewiss (1978) related the weekly change in GNMA security prices to

10-year government bonds, seeking to identify changes in the behavior of
GNMA securities after future trading on GNMA securities began. He
concluded that future trading did not destabilize the GNMA securities market.

Figlewski (1981), however, found that the volatility of the GNMA

security market is related to several factors, including future trading. The
amount of GNMAs outstanding, which proxies for cash market liquidity, is
found to lower cash market volatility, as does a lower average price for the
GNMA. Future trading was found to increase GNMA security volatility, and
suggested that the new traders in the GNMA market, because of the advent of

7
future trading, were likely to add noise to GNMA securities trading. Simpson
and Ireland (1982), however, used both a cross-sectional, time to suggest that
future trading has had no impact on the cash market volatility of GNMA
securities

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III. METHODOLOGY

i. DATA

Information on prices and trading volume on the individual stocks will

be obtained from the online data base of Karachi Stock Exchange. The data
items for these stocks include daily high, low and closing prices and daily
trading volume. The data period covers 1st November, 2001 to 31st March,
2008.

ii. Stock Returns

The daily returns on the individual stocks will be computed based on

daily closing prices.

Following Robani and Bhyan (2005), stock prices will be calculated

using the following formula.

R it =Ln(P t ) – Ln (P t 1 ) (1)

Where

R it = Returns for stock i on day t

Pt = Daily closing price of stock i on day t

P t 1 = Daily closing price of stock on previous day ( t 1 )

Ln = Natural logarithm

Both the traditional method of volatility estimation and the generalized

autoregressive conditional heteroscedastic (GARCH) technique will be used in
this thesis. Using the traditional method, both parametric and non-parametric
tests are applied to identify whether there is any shift in the volatility after
futures trading was introduced on the KSE index. The volatility is measured as
the standard deviation of the daily returns for individual stocks. The average
trading volume of pre-futures periods for all individual stocks are computed

9
and tested for any significant shift by using both parametric and non-
parametric techniques.

The statistical methods used to test the impact of future trading on the
underlying stocks include the two-sample F-test for the two measure of
volatility (standard deviation), and the t-test for the return and trading volume.
These techniques, which test whether there is any significant change in the
average daily return, average volatility and average daily trading volume, are
applied for each of the individual stocks. Then, to test whether there is a
significant change in return, volatility and trading volume during the post-
future period compared with the pre-future period for the stocks as a group, the
paired t-test and the Wilcoxon signed-rank test were applied. In order to
perform these tests, average return, daily high-low variance and the mean
trading volume before and after the KSE index future trading date are
computed for each stock. The difference between these two tests is that the
Wilcoxon test does not require the normality assumption for the testing
variable, whereas the t-test does. Both tests are applied to check the robustness
of the analysis irrespective of the underlying assumptions.

As some of the studies indicate that volatility is created because of the

activity of the speculators in the market, it is important to investigate how flow
of information and volatility are related.

Since with the change of information volatility of stock price also

changes, we attempt to model this relationship as a conditional variance using
the GARCH model developed Engle (1982) and Bollerslev (1986). Unlike
ordinary least squared regression, GARCH specifically incorporates the
conditional variances. In other words, this specification shows how current
volatility is affected by past volatility. A GARCH model with orders p and q
can be written as:

Rt =  + 1 R mt + ε t , ε t ψ t 1 N (0, h t ) (2)

10
 q
h t =   +  ε t2i + 
j 1
j ht  j (3)

Where

Rt = individual stock return computed according to equation (1)

 = Constant

Rmt = Market portfolio. In this thesis daily closing value of KSE-

100 Index, a benched marked stock index for Pakistan’s stock market, is taken
as a proxy for market portfolio.

εt = Error term

ht = Standard deviation of ε t

ε t2i = Squared error term of the previous period

h t 1 = standard deviation of ε t of the previous period

Where Equation (2) is the conditional mean equation, and Equation (3)
is the conditional variance equation. Rt is the individual stock return and Rmt
is the market portfolio return. Hence KSE-100 Index is taken a proxy for
market portfolio.

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 IV. LITERATURE CITED

Akgiray, V. (1989). Conditional heteroscedasticity in time series of stock returns:

Evidence and forecasts. Journal of Business. 62, 55-80.

Andersen, T. & T. Bollerslev. (1997). Intra-day periodicity and volatility persistence

in financial markets. Journal of Empirical Finance. 4, 115-158.

Antoniou, A. & P. Holmes. (1995). Future trading, information and spot price
volatility: Evidence for the FTSE-100 stock index future contract using
GARCH. Journal of Banking and Finance. 19, 117-129.

Antoniou, A., P, Holmes & R. Priestley. (1998). The effects of stock index future
trading on stock index volatility: An analysis of the asymmetric response of
volatility to news. Journal of Future Market. 18, 151-166.

Arditti, F. & K. John. (1980). Spanning the state space with options. Journal of
Financial and Quantitative Analysis. 15, 1-9.

Baillie, R. & T. Bollerslev. (1990). Intra-day and inter-market volatility in foreign

exchange rates. Review of Economic Studies. 58,565-585.

Baldauf, B. & G. Santoni. (1991). Stock price volatility. Some evidence from and
ARCH model, Journal of Futures Markets. 11, 191-200.

Bollerslev, T. (1986). Generalized Autoregressive Conditional Heteroskedasticity. Journal of

Econometrics. 31,307-327.

Breeden, D. & R. Litzenberger. (1978). Prices of state contingent claims implicit in

option prices. Journal of Business. 51,621-652.

Danthine, J. (1978). Information, Futures Prices, and Stabilizing Speculation. Journal

of Economic Theory. Vol. 17 (1): 79-98.

Edwards, F. (1988a). Does futures trading increase stock market volatility ? Financial
Analysts Journal. 44, 63-69.

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Edwards, F. (1988b). Future trading and cash market volatility: stock index and
interest rate future. Journal of Future Market. 8, 421-439.

Engle, R.R. (1982). Autoregressive Conditional Heteroscedasticity with Estikates of

the Variance of United Kingdom Inflation. Econometrica. Vol. 50 (2): 987-
1008.

Figlewski, S. (1981). GNMA pass-through securities, future trading and volatility in

the GNMA market. Journal of Finance. 36, 445-456.

Foster, A. (1995). Volume- volatility relationships for crude oil futures market.
Journal of Future Market. 15, 929-951.

French, K., G. Schwert & R. Stambaugh. (1987). Expected stock returns and
volatility. Journal of Financial Economics. 19, 3-29.

Froewiss, K. (1978). GNMA future: stabilizing or destabilizing? Economic Review,

Federal Reserve Bank of San Francisce. 20-29.

Glosten, L., R. Hagannathan & D. Runkle. (1993). On the relation between the
expected value and the volatility of the normal excess return on stocks. Journal
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Hakansson, N. (1978). Welfare aspects of options and super shares. Journal of

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Harris, L. (1989). S & P 500 cash stock price volatilities. Journal of Finance.
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Hogan, K., K. Kroner & J. Sultan. (1997). Program trading, nonprogram trading, and
market volatility. Journal of Future Markets. 17, 733-756.

Kim, D. & S. Kons. (1994). Alternative models for the conditional heteroskedasticity
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Kyriacou, K. & L. Sarno. (1999). The temporal relationship between derivatives
trading and spot market volatility in the U.K: Empirical analysis and Monte
Carlo evidence. Journal of Future Market. 19,245-270.

Lamoureux, G. & W, Lastrapes. (1990). Heteroskedasticity in stock return data:

volume versus GARCH effect. Journal of Finance. 45,221-229.

Lee, S. & K. Ohk. (1992). Stock index futures listing and structural change in time
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Locke, P. & G. Sayers. (1993). Intra-day futures price volatility: information effects
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Muhammad, G Robbani, Rafiqul Bhyan. (2005). Derivatives Use, Trading and

Regulation. Vol 11 (3): 246-260.

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volatility. Journal of Future Markets. 17(2): 957-974.

Ross, S. (1977). Options and efficiency. Quarterly Journal of Economics. 4, 129-176.

Schwert, G. & P. Segein. (1990). Heteroskedasticity in stock returns. Journal of

Finance . 45,1129-1155.

Schwert, G.W. (1990). Stock market volatility: Financial Analysts Journal. 46,23-34.

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Stein, J. (1987). Informational externalities and welfare reducing speculation. Journal

of Political Economy. 95, 1123-1145.

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