Impact of Derivatives Products On Volatility MKT

CAPSTONE PROJECT 201 0
CAPSTON E PROJECT 2010
A Study on the Impact of Derivatives
Products & Other Macro- Economic Factors on the Volatility of Markets (Cash &Spot Markets)
SUBMITTED BY: SURBHI LOHIA ROLL NO. 49 SUBMITTED BY: PROJECT LOHIA SURBHI GUIDE: ROLL SURYA PROF. NO. 49
2 ITM BUSINESS SCHOOL
NARAYAN PROJECT GUIDE: PROF. SURYA NARAYAN
ACKNOWLEDGEMENT
A research project requires excessive amount of insights and information. Any information can be critical and as such identification of this information is of utmost importance. While preparing and working out this report on Study on the Impact of Derivatives Products & Other MacroEconomic Factors on the Volatility of Markets (Cash &Spot Markets) during Capstone Project, a serious need of an itinerary was felt. This report being a part of MBA evaluation process made entire task very demanding and challenging. The direction that was most sought after was given to me by Prof. Surya Narayan, a pool of wisdom, who listened to me patiently every time I visited him, and tried to give me the vision I was lacking. He gave me fresh insights of key inputs related to the project. I extend my gratitude to some of my friends who as well gave me

critical database they had, which proved beneficial in the preparation of my report. This report perturbed me at times, due to lack or mismatch of records on official websites, so I apologize and thank everyone for bearing eccentricities.
TABLE OF CONTENTS OBJECTIVE OF THE PROJECT METHODOLOGY ADOPTED INTRODUCTION INDIAN DERIVATIVES MARKET-AN OVERVIEW SIZE OF THE INDIAN DERIVATIVES MARKET CURRENT REGULATORY FRAMEWORK GOVERNING THE INDIAN MARKET TYPES OF DERIVATIVES FUTURES CONTRACT FORWARD RATE AGREEMENT OPTIONS
3 3 4 5 5
9 10 11

SWAPS ECONOMIC BENEFITS OF DERIVATIVES RISK ATTACHED WITH DERIVATIVES IMPACT OF VARIOUS DERIVATIVES PRODUCTS ON MARKET SCOPE OF THE PROJECT AFFECTS ON VOLATILITY OF SPOT MARKET EMPIRICAL ANALYSIS CONCLUSION REFERENCES 12 14 14 15 17 18 20 30 31
OBJECTIVE OF THE PROJECT

The project will primarily throw light on the following aspects related to the market:
An Overview of the Indian Derivatives Market An Understanding of the various Derivatives instruments available Identifying the impact of Derivatives instruments on the volatility of the markets Analyzing other macro-economic factors affecting the market

Comparison of the impacts caused on the volatility of the markets by the Derivatives instruments & other related macro-economic factor
METHODOLOGY ADOPTED
The project is organized as follows: Collection of secondary data and various reports pertaining to the Indian derivatives market and the other markets. Minute analysis of various data in order to find out their impact on the market. Evaluating the available data with the help of empirical exercise. Drawing conclusions from the above study.
INTRODUCTION
A derivative is a financial instrument whose value is derived from another underlying security or a basket of securities. Traders can assume highly leveraged positions at low transaction costs using these extremely flexible instruments. Derivative products like index futures, stock futures, index options and stock options have become important instruments of price discovery, portfolio diversification and risk hedging in stock markets all over the world in recent times. With the introduction of all the above-mentioned derivative products in the Indian markets a wider range of instruments are now available to investors. Introduction of derivative products, however, has not always been perceived in a positive light all over the world. It is, in fact, perceived as a

market for speculators and concerns that it may have adverse impact on the volatility of the spot market. Recent research, however, strengthens the argument that introduction of these products have not only deepened the markets but have also been instrumental in reduction of volatility in the spot markets.
The index futures were introduced in the Indian stock markets in June 2000 and other products like index options, stock futures and options and interest rate futures followed subsequently. The volumes in derivative markets, especially in the case of National Stock Exchange (NSE), have shown a tremendous increase and presently the turnover in derivative markets is much higher than the turnover in spot markets.
This research report makes an effort to study whether the volatility in the Indian spot markets has undergone any significant change after the introduction of index futures in June 2000 and its impact till date. It also attempts to evaluate whether such volatility change is due to unrelated macroeconomic factors or it could be attributed to the derivative products introduced in the Indian stock markets. This research report is organized as follows: Section I presents the literature survey, Section II assesses the available data presents the methodology and evaluates the results of the empirical exercise and Section III draws conclusions from the study.
AN OVERVIEW OF THE INDIAN DERIVATIVES MARKET
Definition A derivative is any financial instrument, whose payoffs depend in a direct way on the value of an underlying variable at a time in the future. This underlying variable is also called the underlying asset, or just the underlying. Examples of underlying assets include
Usually, derivatives are contracts to buy or sell the underlying asset at a future time, with the price, quantity and other specifications defined today. Contracts can be binding for both parties or for one party only, with the other party reserving the option to exercise or not. If the underlying asset is not traded, for example if the underlying is an index, some kind of cash settlement has to take place. Derivatives are traded in organized exchanges as well as over the counter [OTC derivatives].
Size of Indian Derivatives Market The financial markets, including derivative markets, in India have been through a reform process over the last decade and a half, witnessed in its growth in terms of size, product profile, nature of participants and the development of market infrastructure across all segments - equity markets, debt markets and forex markets. Derivative markets worldwide have witnessed explosive growth in recent past. According to the BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity , the average daily turnover of interest rate and non-traditional foreign exchange contracts increased by 71 % to $2.1 trillion in April 2007 over April 2004, maintaining an annual compound growth of 20 per cent witnessed since 1995. Turnover of foreign exchange options and cross-currency swaps more than doubled to $0.3 trillion per day, thus outpacing the growth in 'traditional' instruments such as spot trades, forwards or plain foreign exchange swaps. The traditional instruments also show an unprecedented rise in activity in traditional foreign exchange markets compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an increase of 71% at current exchange rates and 65% at constant exchange rates. Relatively moderate growth was recorded in the much larger interest rate segment, where average daily turnover increased by 64 per cent to $1.7 trillion. While the dollar and euro clearly dominate activity in OTC interest rate derivatives, their combined share has fallen by nearly 10 percentage points since the 2004 survey, to 70 per cent in April 2007, as turnover growth in several non-core markets outstripped that in the two leading currencies.

Indian forex and derivative markets have also developed significantly over the years. As per the BIS global survey the percentage share of the rupee in total turnover covering all currencies increased from 0.3 percent in 2004 to 0.7 percent in 2007. As per geographical distribution of foreign exchange market turnover, the share of India at $34 billion per day increased from 0.4 in 2004 to 0.9 percent in 2007. The activity in the forex derivative markets can also be assessed from the positions outstanding in the books of the banking system. As of August end, 2007, total forex contracts outstanding in the banks' balance sheet amounted to USD 1100 billion (Rs. 44 lakh crore), of which almost 84% were forwards and rest options. The size of the Indian derivatives market is clearly evident from the above data, though from global standards it is still in its nascent stage. Broadly, Reserve Bank is empowered to regulate the markets in interest rate derivatives, foreign currency derivatives and credit derivatives. Until the amendment to the RBI Act in 2006, there was some ambiguity in the legality of OTC derivatives which were cash settled. This has now been addressed through an amendment in the said Act in respect of derivatives which fall under the regulatory purview of RBI (with underlying as interest rate, foreign exchange rate, credit rating or credit index or price of securities) provided one of the parties to the transaction is RBI, a scheduled bank or any other entity regulated under the RBI Act, Banking Regulation Act or Foreign Exchange Management Act (FEMA). The derivatives market in India has been expanding rapidly and will continue to grow. While much of the activity is concentrated in foreign and a few private sector banks, increasingly public sector banks are also participating in this market as market makers and not just users. Their participation is dependent on development of skills, adapting technology and developing sound risk management practices. Corporate are also active in these markets. While derivatives are very useful for hedging and risk transfer, and hence improve market efficiency, it is necessary to keep in view the risks of excessive leverage, lack of transparency particularly in complex products, difficulties in valuation, tail risk exposures, counterparty exposure and hidden systemic risk. Clearly there is need for greater transparency to capture the market, credit as well as liquidity risks in off-balance sheet positions and providing capital therefore. From the corporate point of view, understanding the product and inherent risks over the life of the product is extremely important. Further development of the market will also hinge on adoption of international accounting standards and disclosure practices by all market participants, including corporate.
Current Regulatory Framework of Derivatives Market in India

In the light of increasing use of structured products and to ensure that customers understand the nature of the risk in these complex instruments, RBI after extensive consultations with market participants issued comprehensive guidelines on derivatives in April 2007, which cover the following aspects: Participants have been generically classified into two functional categories, namely, market-makers and users, which would be specific to the position taken by the participant in a transaction. This categorization was felt important from the perspective of ensuring Suitability & Appropriateness compliance by market makers on users. The guidelines also define the purpose for undertaking derivative transactions by various participants. While Market-makers can undertake derivative transactions to act as counterparties in derivative transactions with users and also amongst themselves, Users can undertake derivative transactions to hedge - specifically reduce or extinguish an existing identified risk on an ongoing basis during the life of the derivative transaction - or for transformation of risk exposure, as specifically permitted by RBI. The guidelines clearly enunciate the broad principles for undertaking derivative transactions: Any derivative structure is permitted as long as it is a combination of two or more of the generic instruments permitted by RBI and Market-makers should be in a position to mark to market or demonstrate valuation of these products based on observable market prices. Further, it is to be ensured that structured products do not contain derivative(s), which is/ are not allowed on a stand alone basis. This will also apply in case the structure contains cash instrument(s). All permitted derivative transactions shall be contracted only at prevailing market rates. The guidelines set out the basic principles of a prudent system to control the risks in derivatives activities. It is required that all risks arising from derivatives exposures should be analyzed and documented and the management of derivative activities should be integrated into the banks overall risk management system using a conceptual framework common to the banks other activities. The critical importance of suitability and appropriateness policies within banks for derivative products being offered to customers (users) have been underlined. It is imperative that market-makers offer derivative products in general, and structured products, in particular only to those users who understand the nature of the risks inherent in these transactions and further that products being offered are consistent with users internal policies as well as risk appetite.
In India, derivatives are traded on the following exchanges inter alia:


1. 2. 3. 4.
Bombay Stock Exchange (BSE) National Stock Exchange (NSE) National Commodity and Derivatives Exchange (NCDEX) Multi Commodity Exchange (MCX)
Types of derivatives Broadly classifying there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market:
Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge. Exchange-traded derivatives are those derivatives products that are traded via specialized Derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), Chicago Mercantile Exchange and the Chicago Board of Trade.
Common contract types of Derivatives There are three major classes of derivatives: Futures/Forward These are contracts to buy or sell an asset at a specified future date. Options These are contracts that give a holder the right (but not the obligation) to buy or sell an asset at a specified future date. Swaps It is an agreement by which two parties agree to exchange cash flows.

Futures contract
Futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cashsettled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.
Forward Rate Agreements (FRA)

A forward rate agreement is a forward contract on interest rate. A FRA is an agreement between the two parties namely the bank and the depositor/borrower where the bank guarantees the depositor/borrower the London Interbank Offered Rate (LIBOR) at an agreed future date. Under a FRA one party is made good by another party on account if the actual interest rate differs from the rate agreed on the date of entering the contract. for example if the agreed 6month LIBOR under FRA is 10% and the actual rate happens to be 9 % then the bank will reimburse to the buyer of the FRA the difference of 1%.while if the actual rate falls to 8% then the buyer will have to pay the difference of 1% to the bank. It is not necessary that the bank will always be the lender of the FRA. The pricing of the FRA is done on the basis of the yield curve in the LIBOR market and it can be hedged through a mismatch or gap in the assets & liabilities.
Forward / Future Contracts: A Distinction

Features Operational Mechanism Contract Specifications Counterparty Risk
Forward Contract Not traded on exchange Differs from trade to trade. Exists
Future Contract Traded on exchange Contracts are standardised contracts. Exists, but assumed by Clearing Corporation/ house. Very high Liquidity as contracts are standardised contracts. Better; as fragmented markets are brought to the common platform.
Liquidation Profile
Poor Liquidity as contracts are tailor maid contracts. Poor; as markets are fragmented.
Price Discovery
OPTIONS
An Option is a derivatives contract which gives the buyer of the option a right but not an obligation to exercise a contract. It includes a call option and a put option. A call option is an agreement in which the buyer (holder) has the right (but not the obligation) to exercise by buying an asset at a set price (strike price) on (for a European style option) or not later than (for an American style option) a future date (the exercise date or expiration); and the seller (writer) has the obligation to honor the terms of the contract. A put option is an agreement in which the buyer has the right (but not the obligation) to exercise by selling an asset at the strike price on or before a future date; and the seller has the obligation to honor the terms of the contract. Since the option gives the buyer a right and the writer an obligation, the buyer pays the option premium to the writer. The buyer is considered to have a long position, and the seller a short position. For every open contract there is a buyer and a seller.
Types of options
Real option - Real option is a choice that an investor has when investing in the real economy (i.e. in the production of goods or services, rather than in financial contracts). This option may be something as simple as the opportunity to expand production, or to change production inputs. Real options are an increasingly influential tool in corporate finance. They are typically difficult or impossible to trade, and lack the liquidity of exchange-traded options.
Traded options (also called "Exchange-Traded Options" or "Listed Options") is a class of Exchange traded derivatives. As for other classes of exchange traded derivatives, trade options have standardized contracts, quick systematic pricing, and are settled through a clearing house (ensuring fulfillment). Vanilla options are 'simple', well understood, and traded options. It includes buy and sell options and are less complex. Exotic Options are more complex than the vanilla options especially if the underlying instrument is more complex than simple equity or debt.
SWAPS
A swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the underlying prices.
Types of Swaps

Interest Rate Swap - An interest rate swap is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction. Currency Swap - A currency swap is exactly the same thing as the interest rate swap except, with an interest rate swap, the cash flow streams are in the same currency. With a currency swap, they are in different currencies. Principal only Swap It involves exchange of principals only between two parties. There is no exchange of regular cash flows in the form of interest. Equity Swaps An equity swap is a contract between two parties where a set of future cash flows are exchanged between them.These cash flows are known as the lefs of the swap.In this types of swaps, one leg is based on a reference interest rate,while the other leg is based on the performance of a particular stock or a basket of stocks. The outstanding performance of equity markets in the 1980s and the 1990s, technological innovations that have made widespread participation in the equity market more feasible and more marketable, has generated significant interest in equity derivatives. In addition to the listed equity options on individual stocks and individual indices, a burgeoning over-the-counter (OTC) market has evolved in the distribution and utilization of equity swaps.And this has led to the growing importance of equity swaps in the modern derivatives market. The advantages of using equity swaps can be listed as below: 1. To avoid transaction costs 2. To avoid local dividend taxes 3. It helps in mitigating the risks attached with the trading of the underlying security 4. Equity swaps make the index trading strategy even easier 5. There are also omneship advantages associated with equity swaps 6. Equity swap is also more convenient for the investment manager for several reasons
Total Return Swap A Total Return Swap is a contract between two parties where one party receives interest payment on a reference asset (any asset, or a basket of assets) plus any capital

gains on dividend thereon,while the other party receives a specified fixed or floating cash flow which is unrelated to the reference asset.The interest payments are floating payments and are usually based upon LIBOR plus certain basis ponts there on as per the contract between the parties. Example: Equity Swaps
Credit Default Swaps A credit default swap is a contract between two parties namely a protection buyer and a protection seller,where the protection buyer makes a periodic payment of fee to the protection seller in exchange of a contingent payment by the seller in case of a credit event happening in the reference entity,such as default or failure to pay.In case of the occurrence of such events,the protection seller either takes the delivery of the defaulted bond for the par value or pays the protection buyer the difference between the par value and recovery value of the bond. A credit default swap is the most widely traded credit derivative product, generally with a contract term of five years. The recent turmoil of the ICICI bank in the overseas losses was on account this credit default swaps only.
ECONOMIC BENEFITS OF DERIVATIVES

Derivatives markets serve the society in two important ways:
By providing risk management and mitigation tools, thereby contributing to the development of complete markets. Derivatives assist in managerial decision-making by providing some information on future prices that will help in production decisions.
RISK ATTACHED WITH DERIVATIVES

Derivatives are complex in nature and retail investors may not understand the risk they bring to the table. There is a risk of mis-pricing or improper valuation of derivatives and the inability of correlating derivatives perfectly with the underlying assets, be it stocks or indices. Further, derivatives are highly leveraged instruments. A small price movement in the underlying security could have a big impact on the value. Adverse price movements, on the other hand, in the underlying asset can either mean phenomenal gains or it could lead to the erosion of the entire margin money. Due to these inherent risks in derivative products, SEBI allows mutual funds to invest in derivatives only for hedging purposes, and not for speculation.
IMPACT OF VARIOUS DERIVATIVES PRODUCTS ON MARKET

The effect of introduction of derivatives on the volatility of the spot markets and in turn, its role in stabilizing or destabilizing the cash markets has remained an active topic of analytic and empirical interest. Questions pertaining to the impact of derivative trading on cash market volatility have been empirically addressed in two ways: by comparing cash market volatilities during the pre-and post-futures/ options trading eras and second, by evaluating the impact of options and futures trading (generally proxies by trading volume) on the behavior of cash markets. The literature is, however, inconclusive on whether introduction of derivative products lead to an increase or decrease in the spot market volatility. One school of thought argues that the introduction of futures trading increases the spot market volatility and thereby, destabilizes the market (Cox 1976; Figlewski 1981; Stein, 1987). Others argue that the introduction of futures actually reduces the spot market volatility and thereby, stabilizes the market (Powers, 1970; Schwarz and Latch, 1991 etc.). The rationale and findings of these two alternative schools are discussed in detail in this section.

The advocates of the first school perceive derivatives market as a market for speculators. Traders with very little or no cash or shares can participate in the derivatives market, which is characterized by high risk. Thus, it is argued that the participation of speculative traders in systems, which allow high degrees of leverage, lowers the quality of information in the market. These uninformed traders could play a destabilizing role in cash markets . However, according to another viewpoint, speculation could also be viewed as a process, which evens out price fluctuations. On the other hand, arguments suggesting that the future and option markets have become important mediums of price discovery in cash markets are equally strong. Several authors have argued that trading in these products improve the overall market depth, enhance market efficiency, increase market liquidity, reduce informational asymmetries and compress cash market volatility. The debate about speculators and the impact of futures on spot price volatility suggests that increased volatility is undesirable. This is, however, misleading as it fails to recognise the link between the information and the volatility (Antoniou and Holmes, 1995). Prices depend on the information currently available in the market. Futures trading can alter the available information for two reasons: first, futures trading attract additional traders in the market; second, as transaction costs in the futures market are lower than those in the spot market, new information may be transmitted to the futures market more quickly. Thus, future markets provide an additional route by which information can be transmitted to the spot markets and therefore, increased spot market volatility may simply be a consequence of the more frequent arrival and more rapid processing of information. It has been argued that the introduction of derivatives would cause some of the informed and speculative trading to shift from the underlying cash market to derivative market given that these investors view derivatives as superior investment instruments. This superiority stems from their inherent leverage and lower transaction costs. The migration of informed traders would reduce the information asymmetry problem faced by market makers resulting in an improvement in liquidity in the underlying cash market. In addition, it could also be argued that the migration of speculators would cause a decrease in the volatility of the underlying cash market by reducing the amount of noise trading. This hypothesis would also suggest that the advent of derivatives trading would be accompanied by a decrease in trading volume in the underlying security.
SCOPE OF THE PROJECT

A comparison is made between the impact caused by the introduction of derivatives products and the other macro-economic factors on the increase or decrease in the volatility of the cash/spot markets with the help of empirical analysis (Details of the empirical analysis will be given later in the project report). Daily data for BSE Sensex and S&P CNX Nifty have been used for the period January 1997 to March 2003, for this purpose. Along with these two series on which derivative products are available, we will also consider the volatility on the broad based BSE-200 and Nifty Junior on which derivative products have not been introduced. Though BSE and NSE prices are tightly bound by arbitrage, the derivative turnover differs considerably among these markets (with the NSE recording a maximum turnover in the derivative market). A comparison of fluctuations in volatility between BSE-200/Nifty Junior and Sensex/Nifty may provide a clue to segregate the fluctuations due to introduction of future products and due to other market factors. There are several broad based indices available like BSE-100, BSE-200, BSE-500 and Nifty Junior. However, longer time series is available only for Nifty Junior and BSE 200. These indices also capture 80 to 90 per cent of market capitalization of the BSE or the NSE and therefore, they are chosen as surrogate indices.

The empirical exercise attempts to evaluate whether the introduction of index futures had any significant impact on the spot stock return volatility. It uses the daily BSE Sensex returns and daily S&P CNX Nifty returns along with returns on BSE-100, BSE-200 and BSE-500 to evaluate the impact of these policy changes on the stock returns volatility. With the help of this analysis we can analyze whether the volatility changes in the cash or spot markets during the period, is on account of the introduction of various derivatives products or is related to certain other macroeconomic factors, which speaks about the scope of this project.
AFFECTS ON THE VOLATILITY OF SPOT MARKETS

The effect of introduction of derivatives on the volatility of the spot markets and in turn, its role in stabilizing or destabilizing the cash markets has remained an active topic of analytic and empirical interest. Questions pertaining to the impact of derivative trading on cash market volatility have been empirically addressed in two ways: by comparing cash market volatilities during the pre-and post-futures/ options trading eras and second, by evaluating the impact of options and futures trading (generally proxied by trading volume) on the behavior of cash markets. One school of thought argues that the introduction of futures trading increases the spot market volatility and thereby, destabilizes the market (Cox 1976; Figlewski 1981; Stein, 1987). Others argue that the introduction of futures actually reduces the spot market volatility and thereby, stabilizes the market (Powers, 1970; Schwarz and Laatsch, 1991 etc.). The rationale and findings of these two alternative schools are discussed in detail in this section. The advocates of the first school perceive derivatives market as a market for speculators. Traders with very little or no cash or shares can participate in the derivatives market, which is characterized by high risk. Thus, it is argued that the participation of speculative traders in systems, which allow high degrees of leverage, lowers the quality of information in the market. These uninformed traders could play a destabilizing role in cash markets. However, according to

another viewpoint, speculation could also be viewed as a process, which evens out price fluctuations. The debate about speculators and the impact of futures on spot price volatility suggests that increased volatility is undesirable. This is, however, misleading as it fails to recognize the link between the information and the volatility. Prices depend on the information currently available in the market. Futures trading can alter the available information for two reasons: first, futures trading attract additional traders in the market; second, as transaction costs in the futures market are lower than those in the spot market, new information may be transmitted to the futures market more quickly. Thus, future markets provide an additional route by which information can be transmitted to the spot markets and therefore, increased spot market volatility may simply be a consequence of the more frequent arrival and more rapid processing of information. On the other hand, arguments suggesting that the future and option markets have become important mediums of price discovery in cash markets are equally strong. Several authors have argued that trading in these products improve the overall market depth, enhance market efficiency, increase market liquidity, reduce informational asymmetries and compress cash market volatility . It has been argued that the introduction of derivatives would cause some of the informed and speculative trading to shift from the underlying cash market to derivative market given that these investors view derivatives as superior investment instruments. This superiority stems from their inherent leverage and lower transaction costs. The migration of informed traders would reduce the information asymmetry problem faced by market makers resulting in an improvement in liquidity in the underlying cash market. In addition, it could also be argued that the migration of speculators would cause a decrease in the volatility of the underlying cash market by reducing the amount of noise trading. This hypothesis would also suggest that the advent of derivatives trading would be accompanied by a decrease in trading volume in the underlying security. In a recent study, Bologna and Cavallo (2002) investigated the stock market volatility in the post derivative period for the Italian stock exchange using Generalised Autoregressive Conditional Heteroscedasticity (GARCH) class of models. To eliminate the effect of factors other than stock index futures (i.e., the macroeconomic factors) determining the changes in volatility in the post derivative period, the GARCH model was estimated after adjusting the stock return equation for market factors, proxied by the returns on an index (namely Dax index) on which derivative products are not introduced. This study shows that unlike the findings by Antoniou and Holmes (1995) for the London Stock Exchange (LSE), the introduction of index future, per se, has actually reduced the stock price volatility. Bologna and Covalla also found that in the post Index-future period the importance of present news has gone up in comparison to the old news in determining the stock price volatility.

A few studies have been undertaken to evaluate the effect of introduction of derivative products on volatility of Indian spot markets. These studies have mainly concentrated on the NSE, and the evidence is inconclusive in this regard. While Thenmozhi (2002) showed that the inception of futures trading has reduced the volatility of spot index returns due to increased information flow. According to Shenbagaraman (2003), the introduction of derivative products did not have any significant impact on market volatility in India. In the present study, following Bologna and Cavallo (2002) a GARCH model has been used to empirically evaluate the effects on volatility of the Indian spot market and to see that what extent the change (if any) could be attributed to the of introduction of index futures. We use BSE-200 and Nifty Junior as surrogate indices to capture and study the market wide factors contributing to the changes in spot market volatility. This gives a better idea as to: whether the introduction of index futures in itself caused a decline in the volatility of spot market or the overall market wide volatility has decreased, and thus, causing a decrease in volatility of indices on which derivative products have been introduced. Finally, the studies in the Indian context have evaluated the trends in NSE and not on the Stock Exchange, Mumbai (BSE) for the reason that the turnover in NSE captures an overwhelmingly large part of the derivatives market. However, since the key issue addressed here is the volatility of the cash market as affected or unaffected by the derivative market, the importance of evaluating the trends in BSE as well was felt and the empirical analysis was carried out likewise.
EMPIRICAL ANALYSIS
An empirical analysis is a tool for testing on real problems. The advantage of using empirical analysis is that it helps in solving problems in the way in which we are interested in. It helps in analyzing and simulating the problem in much easier way. For the purpose of comparison between the impacts of derivative products and the other related macro-economic factors I have used this empirical analysis which will involve some mathematical calculations for analyasing the available data, with BSE and Nifty as the underlying. Daily data for BSE Sensex and S&P CNX Nifty have been used for the period January 1997 to March 2003. Along with these two series on which derivative products are available, we also consider the volatility on the broad based BSE-200 and Nifty Junior on which derivative products have not been introduced. Though BSE and NSE prices are tightly bound by arbitrage, the derivative turnover differs considerably among these markets (with the NSE recording a

maximum turnover in the derivative market). A comparison of fluctuations in volatility between BSE-200/Nifty Junior and Sensex/Nifty may provide a clue to segregate the fluctuations due to introduction of future products and due to other market factors. There are several broad based indices available like BSE-100, BSE-200, BSE-500 and Nifty Junior. However, longer time series is available only for Nifty Junior and BSE 200. These indices also capture 80 to 90 per cent of market capitalization of the BSE or the NSE and therefore, they are chosen as surrogate indices. The empirical exercise attempts to evaluate whether the introduction of index futures had any significant impact on the spot stock return volatility. It uses the daily BSE Sensex returns and daily S&P CNX Nifty returns along with returns on BSE-100, BSE-200 and BSE-500 to evaluate the impact of these policy changes on the stock returns volatility. Following Bologna and Cavallo (2002), this paper uses Generalised Autoregressive Conditional Heteroscedasticity (GARCH) framework to model returns volatility. The GARCH model was developed by Bollerslev (1986) as a generalised version of Engles (1982) Autoregressive Conditional Heteroscedasticity (ARCH). In the GARCH model the conditional variance at time t depends on the past values of the squared error terms and the past conditional variances.
The GARCH (p,q) model suggested by Bollerslev (1986) is represented as follows:
Where Y t is the dependent variable and is X is a set of independent variable(s). ? t is the GARCH error term with mean zero and variance h t .

The GARCH (1,1) framework has been extensively found to be most parsimonious representation of conditional variance that best fits many financial time series (Bollerslev, 1986; Bologna and Cavallo, 2002) and thus, the same has been adopted to model stock return volatility. The model specification is as follows:
where R t is the lagged R t - 1 is the daily return on the BSE Sensex and return. As regards the conditional variance, following Bologna and Cavallo (2002), it has been augmented with a dummy variable which D f, takes value zero for the pre-index-futures period and one for the postindex-futures period. The direction and the magnitude of the dummy variable coefficients are used to infer whether the introduction of index futures could be related to any change in the volatility of the spot market. This exercise also estimates the coefficients of the GARCH model separately for the pre-index future and post-index future period to have a deeper insight in the change in the values of the coefficients and their implications on the stock return volatility.
The results of the analysis taking into account different underlying rae presented in the tables below:
Table 1: Changes in Volatility in BSE Sensex after the Introduction of Index Futures l
a
Estimates for the Whole Period


0.05 (0.19) 0.11 (0.00) 0.55 (0.00) 0.18 (0.00) 0.69 (0.00) -0.28 (0.00)
Before the Introduction of Index Future 0.10 (0.12) 0.09 (0.02) 0.44 (0.01) 0.12 (0.00) 0.76 (0.00)
After the Introduction of Index Future 0.03 (0.53) Note : 0.13 (0.00) 0. 32 (0.00) 0.26 (0.00) 0.61 (0.00)
P-values are reported in parentheses.
The first two rows of the Table 1 present the result for the whole period under consideration for BSE Sensex. It shows the coefficient of the index-futures dummy variable (l = -0.28) is significant at one per cent level, which is indicative of the fact that the introduction of index futures might have made a difference in the volatility of BSE Sensex returns. The negative sign of the dummy variable coefficient is suggestive of the reduction in the volatility. This preliminary result supports the hypothesis that the introduction of index future has reduced the volatility in the BSE spot market, even though derivative turnover is quite low in BSE as compared with NSE.
The results reported in Table 1 presents estimate of the GARCH model coefficient for the pre-future trading and post-future trading periods. The coefficients reported in Table 1 support the findings of the Antoniou and Holmes (1995) and Bologna and Cavallo (2002). It shows that in the GARCH variance equation the b1 components have gone up and b2 components have actually gone down in the post Index-future period and these estimates are significant at one per cent level. The b1 component is the coefficient of square of the error term and the b2 represents the co-efficient of the lagged variance term in the GARCH variance equation. Both Antoniou and Holmes (1995) and Bologna and Cavallos (2002) papers have referred b1 as the effect of

recent news and b2 capturing the effect of old news. Thus, in line with the findings in the UK and Italy, the result reported here supports the hypothesis that introduction of index futures have actually increased the impact of recent news and at the same time reduced the effect of uncertainty originating from the old news.
The Index futures were introduced only in the BSE Sensex and not in the other (e.g., BSE100, BSE-200 and BSE-500) indices available on the BSE. Moreover, futures trading was introduced in most of the scrips included in the BSE Sensex. Thus, if index and stock futures were the only factors instrumental in reducing the spot price volatility then the reduction in volatility is expected to be more in the case of the BSE Sensex in comparison to the other indices available in BSE. In an attempt to evaluate whether the introduction of futures was the only reason behind the reduction of volatility in BSE Sensex, the same GARCH model with the same dummy variable was used to evaluate the changes in volatility for the BSE-100, BSE-200 and BSE-500. Table 2 shows the estimated coefficients of the model where the dummy variable represents the inception of index future.

Table 2: Changes in Volatility after the Introduction of Index Futures l
a
For BSE-100 0.07 (0.05) For BSE-200 0. 08 (0.05) For BSE-500 0. 08 (0.11) 0.11 (0.00) 0.28 (0.00) 0.14 (0.00) 0.81 (0.00) -0.14 (0.00) 0.13 (0.00) 0. 32 (0.00) 0.15 (0.00) 0.78 (0.00) -0.08 (0.00) 0.13 (0.00) 0. 44 (0.00) 0.21 (0.00) 0.68 (0.00) -0.15 (0.00)
Note : P-values are reported in parentheses.
The estimated l coefficients of the modified GARCH model (which were significant at one per cent level) reported in column 6 of Table 2 are indicative of the reduction in volatility in the post-index future period. The GARCH results obtained for BSE-100, BSE-200 and BSE-500 are counterintuitive to the argument of index future being unambiguously responsible for the reduction in the BSE Sensex volatility in the post Index future period and indicative of the fact that it is more likely that the stock market and economy wide factors were responsible for the reduction in volatility of the BSE Sensex in the period under consideration. In order to address the issue of whether introduction of index future has been the only factor instrumental in reducing volatility, we use the technique of Bologna and Cavallo (2002) where they included the returns from a surrogate index (in our case BSE-200) into GARCH equation to control the additional factors affecting the market volatility. The augmented set of equations is as follows
Rt= a0+ a1Rt-1 + a2Rt BSE-200 +? t
? t / ? t-1~ N (O, ht)
ht = bo +b1? 2 + t-1 b2 ht-1+lDf The estimation based on the above-mentioned set of equations is provided in Table 3 below. The l coefficient is significant but shows extremely low positive value. It suggests that under the augmented GARCH model, the so called futures effect (the reduction in the spot index return volatility after the introduction of future products) has disappeared in the case of BSE Sensex. However, a comparison of the results of the pre-futures and post-futures period in the new model shows that the b1 and b2 components have followed the same path as before. In particular, the importance of recent news has increased in the post-futures period and the impact of the old news has decreased. Moreover, the most noticeable factor here is that b2 coefficient is not significant in the post index future period. This is in line with Antoniou and Holmes (1995) result, which suggests that the introduction of futures have improved the quality of information flowing to the spot market. The overall impact of index futures on the spot index volatility is ambiguous. The empirical evidence in this paper however strongly suggests that the stock market volatility in general has gone down during the post future period under consideration.
Table 3: Changes in the Volatility of BSE Sensex after Introduction of Index Futures (after controlling For movement in BSE-200 Nifty Junior) L
a
Estimates for the Whole Period (after controlling for movement in BSE-200) -0.01 (0.29) -0.02 (0.01) 1.02 (0.00) 0.01 (0.00) 0.09 (0.00) 0.90 0.01
(0.00) (0.00)
Estimates for the Whole Period (after controlling for movement in Nifty Junior)
-0.08 (0.09)
-0.01 (0.78)
0.66 (0.00)
1.36 (0.00)
0.11 (0.01)
0.03
0.05
(0.91) (0.00)
Before the Introduction of Index Future
-0.01 (0.54)
-0.03 (0.00)
1.06 (0.00)
0.62 (0.00)
0.17 (0.00)
0.80 (0.00)
After the Introduction of Index Future
-0.07 (0.01)
0.03 (0.11)
0.82 (0.00)
0.30 (0.00)
0.22 (0.00)
0.01 (0.92)

It might be noted that the entire period under consideration was marked by subdued trends in the stock market. While the domestic stock markets have remained sluggish after the stock market scam, the international markets also remained depressed after the terrorist attack in US. At the same time, however the domestic markets witnessed rapid progress amidst in market microstructure. All the scrips listed on the BSE and the NSE are now under the orbit of compulsory rolling settlement. The rolling settlement cycle has been reduced to T+3 and further to T+2 for all the scrips in line with the best international practices.
Corporate governance practices have been made more stringent. Against this backdrop, the empirical results confirm that the overall volatility in BSE spot market declined in the post index future period. The extent to which it could be linked to the futures effect however, remains ambiguous.
A number of studies concentrated only on the volatility changes of S&P CNX Nifty in postfutures period (Thenmozhi, 2002; Raju and Karande, 2003). Majority of the studies have concluded that the introduction of derivative products have resulted in reduction in the cash market volatility. In an attempt to evaluate whether the macroeconomic factors were primarily responsible for reduction in volatility in the NSE, which registers maximum turnover in the derivative segment, we consider the volatility changes in S&P Nifty index. Our empirical analysis in the case of S&P CNX Nifty also supports the earlier findings. As reported in Table 4 the coefficient of the dummy variable capturing the effect of the changes in market volatility after introduction of index future had negative sign (-0.30) and was significant at one per cent level. In an attempt to segregate the futures effect from the other factors causing the decline in cash market volatility, BSE-2001 was once more used as the surrogate index and the results of the augmented GARCH model are presented in Table 4 below.
Table 4:
Changes in Volatility of S&P CNX Nifty after

Introduction of Index Futures L
a
Estimates for the Whole Period 0.05 (0.13) 0.10 0.49 (0.00) 0.12 (0.00) 0.74 -0.30
(0.00) -
(0.00) (0.00)
GARCH Estimate (after controlling for movement in BSE-200) 0.02 (0.08) 0.14 0.86 0.01 (0.00) 0.03 (0.00) 0.96 -0.01
(0.16) (0.00)
(0.00) (0.00)
GARCH Estimate (after controlling for movement in Nifty Junior) 0.05 (0.14) 0.10 0.02 0.50 (0.00) 0.12 (0.00) 0.75 -0.28
(0.00) (0.31)
(0.00) (0.00)
The result shows that the dummy coefficient (-0.01) has taken negative value even after adjusting for the market factors and it is significant even though the magnitude of such effect has gone down considerably. This finding supports the earlier work for S&P CNX Nifty and shows that unlike BSE Sensex, futures trading have a significant role in reducing volatility of S&P CNX Nifty, over and above the market factors. The empirical findings of this section could be summarised by saying that there has been reduction in the spot market volatility in the recent years (after June 2000), which could be attributed to macroeconomic changes. This is evident from the reduction in volatility documented

in BSE-100, BSE-200 and BSE-500 indices where derivative products were not introduced. BSE Sensex also witnessed reduction in volatility. Though derivative products are available on BSE Sensex, the reduction in volatility in the post derivative period fades away when we control for the market movement through a surrogate index. These findings indicate that the change in BSE Sensex spot volatility was mainly due to the market wide changes and not due to the futures effect. However, an analysis in the same framework shows different results for S&P CNX Nifty. Even after controlling for the market movement through surrogate index for S&P CNX Nifty, the volatility in the cash market shows significant signs of reduction, which could be due to the futures effect? The differences in the empirical finding between these two indices could be because of large turnovers in the derivative segment in the S&P CNX Nifty index as opposed to BSE Sensex, which makes the futures effect to be significant in the former index.
CONCLUSION
Using ARCH/GARCH methodology, this article evaluated the impact of introduction of derivative products on spot market volatility in Indian stock markets. We found that the volatility in both BSE Sensex and S&P CNX Nifty has declined in the period after index future was introduced. Recognising the fact that the decline in volatility is a function of not only introduction of derivative products, but also certain market wide factors, we evaluated the volatility of BSE-100, BSE-200 and BSE-500 indices (where index futures have not been

introduced) which showed a decline and indicated that the other market wide factors might have played an important role in the observed decline in volatility of BSE Sensex and S&P CNX Nifty. In order to control the market-wide factors, we used BSE-200 and Nifty Junior as surrogate indices in the GARCH model. Using this model, we found a reduction in volatility of S&P CNX Nifty even after controlling for market wide factors. The volatility of BSE Sensex, however, showed an increase, which is not in line with the expectations. This result indicates that the decline in volatility of BSE Sensex was mainly due to the overall decline in market volatility. S&P CNX Nifty, however, incorporated the contribution of both the market factors as well as the futures effect. This is due to increased impact of recent news and reduced effect of uncertainty originating from the old news. In conclusion, the empirical results of this study indicate that there has been a change in the market environment since the year 2000, which is reflected in the reduction in volatility in all the BSE indices and S&P CNX Nifty. The impact of a derivative product, however, on the spot market depends crucially on the liquidity characterising the underlying market. This is evident from the differential results obtained for BSE Sensex and S&P CNX Nifty. It may be added, that turnover in the derivative market of BSE constitutes not only a small part of the total derivative segment, but is miniscule as compared to BSE cash turnover. Thus, while BSE Sensex incorporates only the market effects, the reduction in volatility due to futures effect plays a significant role in the case of S&P CNX Nifty.
REFERENCES
www.rbi.org Bank of International Settlements (BIS) reports Securities and Exchange Board of India (SEBI) regulations Financial Derivatives by S.S.S Kumar

Powers M J (1970): Does Futures Trading Reduce Price Fluctuations in the Cash Markets?,American Economic Review, 60, 460-4.
Other reports on Derivatives and Derivatives instruments Nifty Junior has been used as a surrogate index to capture the effect of macroeconomic factors on the spot price volatility of S&P CNX Nifty.
Bologna, P and L. Cavallo (2002): Does the Introduction of Stock Index Futures
Effectively Reduce Stock Market Volatility? Is the Futures Effect Immediate? Evidence from the Italian stock exchange using GARCH, Applied Financial Economics
Bollerslev T. (1986): Generalised Autoregressive Conditional Heteroscedasticity
Journal of Econometrics

Impact of Derivatives Products On Volatility MKT

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CAPSTONE PROJECT 201 0

CAPSTON E PROJECT 2010

A Study on the Impact of Derivatives

NARAYAN PROJECT GUIDE: PROF. SURYA NARAYAN

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OBJECTIVE OF THE PROJECT

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AN OVERVIEW OF THE INDIAN DERIVATIVES MARKET

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Current Regulatory Framework of Derivatives Market in India

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In India, derivatives are traded on the following exchanges inter alia:

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Forward Rate Agreements (FRA)

Forward / Future Contracts: A Distinction

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Features Operational Mechanism Contract Specifications Counterparty Risk

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ECONOMIC BENEFITS OF DERIVATIVES

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RISK ATTACHED WITH DERIVATIVES

IMPACT OF VARIOUS DERIVATIVES PRODUCTS ON MARKET

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SCOPE OF THE PROJECT

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AFFECTS ON THE VOLATILITY OF SPOT MARKETS

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The GARCH (p,q) model suggested by Bollerslev (1986) is represented as follows:

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Estimates for the Whole Period

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P-values are reported in parentheses.

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Note : P-values are reported in parentheses.

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Rt= a0+ a1Rt-1 + a2Rt BSE-200 +? t

? t / ? t-1~ N (O, ht)

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Before the Introduction of Index Future

After the Introduction of Index Future