Research Literature Review

“Volatility Integration in Spot, Futures and Options Markets: A Regulatory

Perspective”

Introduction

This study attempts to identify the congruence of volatility in three markets i.e. spot markets,
futures markets and options markets. Volatility measures the changes in the prices in the
markets in the past. It is proven to be a better indicator of future prices when compared to the
exact price per se, as investors are more drawn towards the changes in prices rather than the
price alone. The existing studies that are available are primarily on any two of the three
markets and usually focuses on price or volume. None of the existing studies discusses
volatility in all three markets simultaneously. Structural break is an abrupt and unexpected
change at a point in time in a given time series. This study has shown two such structural
breaks. First in May 2014, when the political scene in India changed with BJP coming in to
power and Narendra Modi taking oath as the Prime Minister. The second in November 2016,
globally impacted by the ascension of Donald Trump as the new President of United States
and domestically, by the news of demonetization of two major currency notes. The objectives
of this study are to analyse the long term integration of volatility in all the three markets
(spot, options and futures) and to compare the same before and after these structural breaks.

Summary of the Analysis

Literature on association of volatility in the three markets i.e. spot, options and futures is
relatively less when compared to the literature on the same in any of two markets of the three.
There are two hypotheses that are proposed for the present study:

Hypothesis 1 is that the volatility in the three markets that have been undertaken in this study
shows a long term association.

Hypothesis 2 is to show the change in the degree of volatility association in the three markets
during the stipulated time period pre and post the structural breaks.

The data for spot market was collected from the weekly closing prices of the Nifty 50 for the
period 2010 and 2017. For options, the weekly closing prices of Nifty 50 index options for
the same time period was collected and for futures, the weekly closing prices of Nifty 50
index futures were taken. Options and futures on the index trade for three months. In
derivatives, when the profits or loss in the current month contracts are booked and a new
position is opened in the next or later month’s contract, a rollover is said to occur. For the
purpose of obtaining a continuous time series, rollover is assumed in this paper.

Co integration is the existence of a long term association between two or more variables. It
analyses variance in non-stationary time series. All the four variance series (index, index
future, index call option and index put option) are not Gaussian. At 5 % level of significance,
the Augmented Dickey Fuller Test (ADF) shows that all the four series are stationary at level
i.e. p value of all the series is less than 5%. Since all the three markets are stationary at level,
co integration cannot be established.

Since the data still shows simultaneity, Generalized Method of Moments (GMM) is applied
in the study. The scope of this paper is to study the integration of volatility in the three
markets; hence it restricts itself to only two lags. Predictability can be an extension to this
study and higher lags can be used then.

The results are reported at three levels: endogeneity, long term association among the
volatility in spot, futures and options markets and the impact of structural breaks on the given
data.

The Durbin-Wu-Hausman test is conducted on all the regression equations for endogeneity.
In each case, each of the variables are taken as the dependant variable individually and tested
for endogeneity. The results show that endogeneity exists only in the case of index call
options, index spot and index future. Index put options shows signs of being exogenous with
the other three variables.

Results using GMM shows that the volatility in index spot market is related to the volatility
in index futures market but not to the index options. The same is observed in the case of
index future market, it is related to the index spot but not to the index options. The variance
in index call options and index put options does not have any long term association with the
index spot and index futures markets. All these models are said to be appropriate since the p
value of the j statistics is higher than the level of significance taken at 5%.

Results from the GMM breakpoint show that in May 2014, the test was significant only in the
case of index call option being the dependant variable. Whereas, in November 2016, the test
was significant in the case of all the four variables as dependant variables. This implies that
November 2016 was felt as a major structural break, when compared to May 2014, for the
volatility integration among the index spot, index futures and index options markets.

Conclusion

The main aim of investing in derivatives is to hedge. The authors say that among the
investment alternatives in the derivatives market, options is seen as a better alternative than
futures as the paper suggests that the volatility in options has no significant relation with the
volatility in spot and futures markets. The research finding of this paper is that the options
market behaves distinctly when compared to the futures market. Another finding that this
paper brought forward was that of the impact of structural breaks. It showed that the
structural break in May 2014 did not cause variations in the three markets. But the structural
break of November 2016 seemed to have a significant impact on the volatility on all three
markets.

Future Prospect of the Research

The authors themselves have spoken about the limitations of the study and have put it up as
future study areas. The findings show that the volatility in spot and future markets are
integrated and that volatility in options has no association to either. The reason for this
dissociation is not explored in this study.

While the title of the research paper is “Volatility Integration in Spot, Futures and Options
Markets: A Regulatory Perspective”, the paper shows no sign of the subject matter from a
regulatory perspective. The paper does talk about the integration of the volatility in the three
markets but nothing has been mentioned about the regulatory approach that has to be or can
be taken when such long term volatility association is found in the spot, futures and options
markets.