SPOT AND FUTURES MARKETS: INTRODUCTION

INTRODUCTION

Indian capital markets have witnessed major transformations and structural changes since past one or two decades as a result of initiation of liberalization, privatization and globalization policies and consequential financial sector reforms. Introduction of derivative instruments like index futures, index options, stock options and stock futures in a phased manner starting from June 2000 in Indian stock exchanges is one such important step in the right direction, the aim of which was to abolish age old badla transaction, greater stabilization of markets and introduction of sophisticated risk management tools. Worldwide, the futures trading on stock markets has grown rapidly since their introduction because it has contributed in achieving economic functions such as price discovery, portfolio diversification, enhanced liquidity, speculation and hedging against the risk of adverse price movements.

The advent of stock index futures and options has profoundly changed the nature of trading on stock exchanges. These markets offer investors flexibility in altering the composition of their portfolios and in timing their transactions. Futures markets also provide opportunities to hedge the risks involved with holding diversified equity portfolios. As a consequence, significant portion of cash market equity transactions are tied to futures and options market activity. In the Indian context, derivatives were mainly introduced with a view to curb the increasing volatility of the asset prices in financial markets; bring about sophisticated risk management tools leading to higher returns by reducing risk and transaction costs as compared to individual financial assets. However, it is yet to be known if the introduction of derivative instruments has served the purpose as was claimed by the regulators.

Today derivatives market in India is more successful and we have around one decade of existence of derivatives market. Hence the present study would use the longer period data to study and compare the behavior of volatility in the spot market after derivatives was introduced. The study would use indices as well as individual stocks for analysis.

The results of this study are crucial to investors, market makers, academicians, exchanges and regulators. Derivatives play a very important role in the price discovery process and in completing the market. Their role as a tool for risk management clearly assumes that derivatives trading do not increase market volatility and risk. Trading in futures is generally expected to reduce volatility in the cash market since speculators are expected to migrate to futures market (Antoniou and Holmes, 1995). Again, the effect of futures on the underlying spot market volatility offers contradictory view. Another view is that derivative securities increase volatility in the spot market due to more highly leveraged and speculative participants in the futures market.

Since there is theoretical disagreement as to whether futures trading increases or decreases spot market volatility, the question needs to be investigated empirically and policy makers in India may also like to know its impact so that future policy changes can be implemented. Frequent and wide stock market variations cause uncertainty about the future value of an asset and affect the confidence of the investors. Risk averse and risk neutral investors may shy away from the market with frequent and sharp price movements. An understanding of the market volatility is thus important from the regulatory policy perspective.

The study is organized as follows. Section II discusses the theoretical debate and summarizes the empirical literature on derivative listing effects, Section III details the model and the econometric methodology used in this study, Section IV outlines the data used and discusses the main results of the model and finally Section V concludes the study and presents directions for future research.