Financial Risk Analysis Topics Essay Example

Do Futures and Options trading increase stock market volatility?

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Abstract

The basic objective of the study is to actually assess the impact of introducing index futures and options contracts on the volatility of the different underlying stock index in India. It has been widely seen where the different studies on the complete effects of futures and option that has been listed over the primary cash market volatility has basically done with the help and support of the developing market. The paper also introduces the derivatives that do not destabilize underlying market. The focus of the paper is also on the introduction of the contracts derivate that shall eventually improve the liquidity and it shall also reduce the information within the market. In 1990s, most of the emerging economies have been introducing the derivative contracts that have been helpful raising the issues that have been quite unique to the differentvolatile markets. The emerging markets have been operating in a rather diverse political, economic, social and also the technological environment within the developed countries such as UK and the US. The paper therefore also looks to explore the impact of introducing the derivative that are used for trading in cash market volatility using the data that has been provided over the stock index futures and also the options contracts that are traded over S&P CNX Nifty in India. The outcome of the study has confirmed that the options and futures trading do not come over and lead to changes in terms of volatility of the decided underlying stock index. There has been no anyindication of a direct linkage between the trading activity in futures market or in the spot market volatility. The result has been therefore integral to the stock exchange market officials and the regulatory also that help in the trading instrument with respect to the specifications of the derivative contracts which enhance the value as the risk management tools.

Table of Contents

Contents

Chapter 01: INTRODUCTION

Background of the study

In the past decade, most of the emerging economies have actually started to introduce the derivative contracts. The research basically considers the idea when the commodity futurewas introduced initially on the Chicago Board of Trade in the year 1865 where the regulators and also the policymakers were concerned over the overall impact of the futures over the primarycash market. Furthermore, a major reason for this issue has been evident in the excerpt which has been issues by John Stuart Mills (1871) where he has stated that complete safety and also the parsimony of the interaction has enabled the limited deficiency from one place to another and it has also used by the complete surplus of different renders the overall fluctuations from the changing price has become rather less. Along with this, the impact is also promoted the complete existence of the different hypothetical merchants. It can be considered as a more useful and a more relevant economy of the society.

The future as per Sutcliffe, (1997), has been encouraging the speculations where the overall impact of the speculators intensified the element of the different future contracts that were initially introduced for the purpose of trading that begins within the commodity of the future and also moving on to the financial futures and also upon the electricity and the weather simultaneously. Finally, this more traditionally and favourable view has been benefiting the economic and the speculative activities that has been acceptable to the different regulators. For instance, the future trading has been considered by some of the stakeholders for the crash of stock market in 1987 in the United States. Therefore, before the further regulations are introduced, it is vital to basically determine and allocate whether there has been any link between the introductions of the spot market volatility.

Research Questions

Do Futures and Options trading increase stock market volatility?

Hypothesis

Futures and Options trading increases stock market volatility.

Futures and Options trading do not increases stock market volatility.

Research Significance

The results for the study are eventually crucial for all the stock exchanges officials, regulators and the investors. Derivates play an important part for the discovery process of the price and also for competing the market. The role for the risk management within the mutual fund and institutional investor industry has also been overemphasized. When firms and individuals trade in derivates then the risk and the volatility of the market does not increases. This study would highlight the important of the derivatives with respect to the volatility of the returns of the cash markets (Stein, 1987).

Structure of the Study

The dissertation consists of five chapters which include the introduction, where the initial description of the concept is explained along with the background which is followed by the research problem, background of the study and the main or the essential objectives for the research. The second chapter, which is the literature review consists of mainly the reviews the wide ranging literature on the topic. Chapter three includes the methodology which looks at the research and the questions to be answered in relation to the research strategy where a particular research method can be used. Along with this the chapter also analyses the data techniques in detail. Chapter four constitutes for the data analysis section which explains the data that is received and it also analyses in quite a simple and moderate way to comply with the focus upon the research in order to reach the research results. Chapter five is the conclusion part where the paper concludes with the recommendations. It also includes the results from the research along with the data interpreted as per the recommendations provided in the study. This chapter of the study presents the overall analysis and interpretation by combining the empirical presentations and the framework different of theories. It is divided logically into three research questions.

Chapter 02: LITERATURE REVIEW

The introduction of the different equity index futures market has basically helped in enabling the traders to come over and transact the larger volume for the lower transaction amount that have been comparative to the cash markets. The different consequences have been helping in increasing the flow of order to the futuremarket that has not been resolved on both the theoretical and also the empirical front. As per the researcher, it has helped in developing the model where the prices are basically determined with the help of interaction between the informed speculators and also the hedgers. In this specific model, the opening of the futures market has two different affects, the future market has helped in improving the risk that is sharing and therefore it helps in reducing the overall price volatility and the other one has been the element of speculators of the noisy but a more informative signal where the hedgers look to react to the changing noise within speculative trades that has helped in the production of the increased volatility (Danthine, 1987).

In comparison to this, the model that has been developed by Danthine (1978) is the argument where the futures market has helped in improving the market depth and it also actually reduces the complete volatility with respect to the cost which has been informing the traders of responding the mispricing is reduced. Along with this, as per Froot and Perold (1991), the model has been showing the market depth that has increased the overall quickdistribution of the market related information that also ensures the existence of the markets within the different futures market with respect to cash market also. As per the research conducted by Ross (1989), has been devoid of the arbitrage and also proceed to help in providing the condition under which is related to the no arbitrage. Furthermore, the defined theoretical work shall be related to the futures inventory effect that does not offer any consensus in terms of the size and also the course of changes that come over in the volatility.

The first stock index futures contracts were first introduced during the Value Line contract that was initiated in the Kansas City Board of the Trade in the year 1982 in the United States. Along with this, there have been numerous markets across the world has been looking to launch thederived contract within each year. The overview of the derivative contracts has been introduced within the market in terms of the volatility and complete competence of the underlying cash related market. Finally, as per Sutcliffe, (1997), the empirical evidence has been quite mixed and complication. In the study, Gulen and Mayhew (2000), has helped in finding the futures trading has been associated with the overall increased volatility within the United States and also in Japan.

Chapter 03: METHODOLOGY

One of the major assumptions has been related to the ordinary regression model that has been related to the error which has been related to the changesample. This basically is considered as thehomoscedasticity model where error needs to be kept idle, that data shall become heterosceasitc. In terms of the least squares regression has been assuming the constant error variance which has also caused the OLS estimates to become inefficient. Furthermore, the model has taken in account the complete changes within variance could help in making well-organized use of data. There have been numerous concepts to deal with the element of heteroscedasitcity. If the error variance within the different times has been weighing the regression an improved method. The error variance has been studying the implicitly assume the complete price changes with respect to the spot markets are looking to focus on the uncorrelated and homoscedastic approach. The finding of the heteroscedasitcity has been related to the stock returns which have been discussed by Mandelbort (1963). Moreover, Fama (19650, the differences has also been related to variances from the futures introduction also. Therefore, GARCH model shall assume the conditional heteroscedasitcity with respect to the homoscedastic variance. The model has assumed modification within the variance of functions of the realizations of the preceding errors that has been representing the different departure with a more continuouscategoricalalteration that shall be used within the daily data. The major advantage of GARCH model has helped in capturing the tendencywithin the financial data for the volatility clustering.

Chapter 04: DATA AND EMPIRICAL RESULTS

The data on the Nifty futures contract looks to open the respect that can be downloaded over the official NSE website. The data that has been provided over the S&P500 index has attained the results from the approximations within the research has been basically conducted using SAS. The SNX Nifty has been presented in the index of 50 stocks has been traded over the National Stock Exchange and also the representation over the 50% of the total market capitalization. The first index with respect to the future in India was initiated on the SNX Nifty in 2000. Along with this the coefficient discussed on the GARCH variable has been nom longer sufficient which helps in spotting the prices changes also. The same has been the result of the 597 observations that needs to be discussed has to be completely cautions. The Chow test is a formal test that helps in evaluating the stability of the regression coefficients. Finally, none of the coefficient on the different trading activities has been significant in the study. The artefact of this has shown low sample size with respect to the post futures period. Finally in the decomposition the volume indicators have not been supportive in terms of the adjustment that has removed the seasonal effects with respect to the expiry months (Wei, 1997).

Chapter 05: CONCLUSION

In the end, as per Gulen (2000), it can be said that the study has looked to examine the impact of introducing Nifty futures and also the options contracts over the spot market volatility which uses the captures with respect to the heteroscedasitcity in terms of the characteristics that create an impact over the stock market returns. The result has also helped in indicating the derivatives by introducing the limited significance over the spot market volatility. This therefore confirms that the result has been robust with no different model specifications. Finally, the research has confirmed that an unexpected induction of the volatility shall not impact upon future. This helps in suggesting the fact that that it has also increased market efficiency that incorporates the prices immediately. It needs to be confirmed that it also requires obtaining the reliable GARCH parameter estimates. It also presented the fact that stock market shall be a more effective and informative in terms of the prices that shall become faster (Gulen, 1999).

References

Danthine, J., 1978, Information, futures prices, and stabilizing speculation, Journal of Economic Theory 17, 79-98.

Fama, E.F., 1965, The behavior of stock market prices, Journal of Business 38, 34-105.

Froot, K.A., and A.F. Perold, 1991, New trading practices and short-run market efficiency, WP MIT.

Gulen, Huseyin and Stewart Mayhew, 1999, The Dynamics of International Stock Index Returns, Working paper, University of Georgia.

Gulen, Huseyin and Stewart Mayhew, 2000, Stock Index Futures Trading and Volatility in International equity markets, Working paper, University of Georgia.

Mandelbrot,B., 1963, The variation of certain speculative prices, Journal of Business 36, 394-419.

Ross, S.A., 1989, Information and volatility: The no-arbitrage martingale approach to timing and resolution irrelevancy, Journal of Finance 44, 1-17.

Stein,J.C., 1987, Informational externalities and welfare-reducing speculation, Journal of Political Economy 95, 1123-1145.

Sutcliffe,C., 1997, Stock Index Futures: Theories and International evidence, 2nd ed., International Thomson Business Press.

Wei,P., P.S. Poon and S.Zee, 1997, the effect of option listing on bid-ask spreads, Price volatility and trading activity of the underlying OTC stocks, Review of Quantitative Finance and Accounting 9(2), 165-80.