Impact on Derivatives

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Reserve Bank of India Occasional Papers Vol. 24, No. 3, Winter 2003

Derivatives and Volatility on Indian Stock Markets
Snehal Bandivadekar and Saurabh Ghosh *
Derivative products like futures and options on Indian stock markets have become important instruments of price discovery, portfolio diversification and risk hedging in recent times. This paper studies the impact of introduction of index futures on spot market volatility on both S&P CNX Nifty and BSE Sensex using ARCH/GARCH technique. The empirical analysis points towards a decline in spot market volatility after the introduction of index futures due to increased impact of recent news and reduced effect of uncertainty originating from the old news. However, further investigation
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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 behaviour 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, destabilises the market (Cox 1976; Figlewski 1981; Stein, 1987). Others argue that the introduction of futures actually reduces the spot market volatility and thereby, stabilises 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 characterised by high risk. Thus, it is argued that the participation of speculative traders in systems, which allow high
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