does futures trading increase stock market volatility?

CFA Institute

Does Futures Trading Increase Stock Market Volatility?Author(s): Franklin R. EdwardsSource: Financial Analysts Journal, Vol. 44, No. 1 (Jan. - Feb., 1988), pp. 63-69Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479091 .

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by Franklin R. Edwards

Does Futures Trading Increase Stock Market Volatility?

Whenever high market volatility occurs, the tendency seems to be to blame it on whatever new is going on at the time. One of the most (if not the most) extraordinary innovations to occur in financial markets in recent years has been the advent and explosive growth of equity futures trading. It is hardly surprising that futures, particularly equity index futures, have been singled out as a possible cause of the recent market volatility.

To focus only on recent events, however, is to ignore most of the evidence. Equity futures began trading in 1982, so there exists a substantial body of data for use in testing the argument that financial futures trading has increased cash market volatility. To date, this evidence does not support the contention that stock index futures trading has destabilized the market.

The day-to-day price volatility of the stock market over the 16-year period from 1972 to May 1987 does not indicate that the introduction of futures trading resulted in an increase in stock price volatility. In fact, market volatility in the S&P 500 was greater in 1973-82, before futures trading began, than it was in the 1982-86 post-futures period. While there is evidence of futures-induced short-run volatility, such as that occurring on futures contract expiration days, this volatility does not appear to carry over to longer periods of time.

T HE LOUDEST AND MOST persistent criticism of futures trading in equity index products has been that such activity

increases the volatility of cash stock prices. Critics point to the "wild" price swings that have occurred on certain futures expiration days, as well as to the yo-yo-like price movements that have taken place on a few non- expiration days, such as September 11 and 12, 1986, and January 23, 1987. On these days, intraday price volatility was severe, although short-lived, lasting for only a few minutes.'

The cause of expiration-day volatility is well known. Such volatility occurs when market participants (such as stock index arbitrageurs) who hold cash positions related to a futures position unwind their positions at the termina-

tion of trading in futures or options contracts. (The cash settlement feature of stock index futures and options contracts makes unwinding positions at the termination of futures trading particularly attractive; by doing so, traders can eliminate any basis risk associated with closing out their positions.) When such trades at the close happen to be predominantly on one side of the market, a substantial order imbalance in the cash market results. If the specialists han- dling the underlying stock cannot provide suffi- cient liquidity, these order imbalances lead to sharp price movements, either up or down. Tables I and II provide clear statistical evidence that there has been unusual volatility at the expiration of S&P 500 futures contracts.

On days other than expiration days, "portfolio insurance" trading, in combination with program trading, may cause unusual stock price volatility. These trading strategies rely on extensive buying or selling of index futures when stock indexes reach a certain predetermined

1. Footnotes appear at end of artide.

Franklin Edwards is Professor and Director of the Columbia Futures Center, Columbia University School of Business.

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1988 0 63



Table II Intraday Volatility on Expiration Days*

Type of from: 10:00 11:00 12:00 1:00 2:00 3:00 Index Expiration to: 11:00 12:00 1:00 2:00 3:00 Close

Day

S&P 500 Normal Days .376 .291 .229 .202 .211 .256 Options/Futures Expire .488 .148 .199 .150 .274 .781+ Options only Expire .267 .193 .160 .170 .243 .229

S&P 100 Normal Days .411 .337 .247 .236 .463 .446 Options/Futures Expire .533 .179 .258 .168 .357 .834+ Options only Expire .260 .243 .200 .213 .305 .320

NYSE Normal Days .304 .259 .179 .187 .203 .220 Options/Futures Expire .361 .139 .153 .153 .274 .581+ Options only Expire .209 .168 .141 .165 .217 .211

Value Line Normal Days .304 .174 .131 .144 .131 .159 Options/Futures Expire .283 .139 .082 .102 .201 .394+ Options only Expire .206 .168 .114 .089 .149 .232

*Volatijty is the standard deviation of percentage changes in the index over the time shown. Data span 7/83 to 10/24/86. For the period 7/83 through 3/84, futures trading terminated on Thursday. However, futures expirations were on Friday from 8/83 onwards. +Significantly greater than normal days at the 5 per cent level of significance, using an F-test with 11 and 114 degrees of freedom.

price. If such buying or selling is not anticipated by market-makers, the result can again be large order imbalances, which sharply raise or lower prices until the market has time to adjust fully. Such order imbalances may result in a tempo- rary liquidity deficiency if there is no adequate market mechanism through which information about anticipated portfolio insurance trading can be conveyed to market-makers. There is at present, however, no evidence that portfolio insurance has caused undue price volatility.2

The current controversy over the impact of futures trading on stock market volatility has focused on short-lived volatility, such as that experienced on expiration days.3 The real issue is whether stock index futures trading poses a long-run threat to market stability. No theoreti- cal papers have addressed the question; most empirical analyses have focused on a few excep- tionally volatile days. This article provides a long-term perspective hitherto missing from the debate.

Why Should Increased Volatility Matter? It is by no means clear that we should be concerned about greater volatility per se. Some have argued that higher volatility raises the risk premium demanded by investors, thereby rais- ing both real interest rates and the cost of capital. But the theory and evidence in support of this notion are questionable; nor are its social welfare implications clear.4

Present concern about stock price volatility

undoubtedly has a much simpler interpretation: Investors are concerned about the present and future value of their investments (and wealth). Greater volatility leads to a perception of greater risk, which threatens investors' assets and wealth. When the stock market takes a sharp nose-dive, investors see the value of their assets rapidly dissipating. They are not consoled by being told that there is no social cost associated with this price change, only a redistribution of wealth. Even more fundamental, when asset prices exhibit significant volatility over very short periods of time (such as a day), investors "lose confidence in the market." They begin to see financial markets as the province of the speculator and the insider, not of the rational,

Table I Relative Volatility on Expiration Days

Index Type of Expiration Day Volatility*

S&P 500 Normal Days 0.723 Options/Futures Expire 1.026 + Options Only Expire 0.541

S&P 100 Normal Days 0.786 Options/Futures Expire 1.178+ Options Only Expire 0.635

NYSE Composite Normal Days 0.705 Options/Futures Expire 0.846 Options Only Expire 0.522

*Volatility is the standard deviation of percentage changes in the index from Thursday close to Friday close. For futures expirations through March 1984, dose-to-close data are for Wednesday to Thursday because futures terminated on Thursday during this period. Data span 7/1/83 to 10/24/86. + Significantly greater than normal days at the 5 per cent level of significance, using an F-test with 11 and 114 degrees of freedom.

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1988 C 64



long-term investor. If this view becomes perva- sive, investors may simply withdraw from the market.

While there is an obvious public perception that increases in volatility are bad, it is difficult to establish concrete links between volatility and either economic activity or economic welfare. Increased volatility may simply reflect fundamental economic factors, or information and expectations about them. In that case, there is no apparent social cost associated with such volatility. In fact, the more quickly and accurate- ly prices reflect new information, the more efficient the allocation of resources will be.5

If volatility either exceeds or falls short of the level indicated by fundamental economic factors, however, the result is mispricing and, as a consequence, misallocation of resources. The controversy over stock index futures has not addressed directly either "excess" or "defi- cient" volatility. By inference, however, we can assume that critics of stock index futures trading believe that such trading results in excess volatility, at least for very short periods of time. The social costs associated with short and infrequent

periods of excess volatility must surely be mini- mal. The key issue, then, is whether stock index futures cause long-run excess volatility.

Has Futures Trading Increased Volatility? Why should the introduction of futures trading increase the volatility of cash markets? Conven- tional wisdom suggests, to the contrary, that futures trading should bring more traders to the cash market, making cash markets more liquid and, therefore, less volatile.

The view that futures trading may increase volatility appears to stem from a belief that futures markets bring with them uninformed (or irrational) speculators, who then trade in the cash market as well as the futures market. Such speculators, it is argued, drive prices up or down in a quest for short-run, "bandwagon" profits. Economists have analyzed this "irrational speculation" argument and have concluded that it would take a considerable number of such speculators to destabilize cash markets.6

The perception nevertheless remains that futures prices are more volatile than cash prices, and that this greater volatility is transmitted to

Figure A Monthly Volatility of S&P 500 (June 1973 to December 1986)

2.1 2 Monetary

1.9 Policy Shift :t Futures Market

1.7 4.KCash Market

1.6- 1.5 1.4 1.3 1.2 5*

.~0.9 7 0.8 7

F 0.7 J /.. 0.6 0.5 0.4 0.3 0.2 0.1

74 75 76 77 78 79 80 81 82 83 84 85 86

FINANCIAL ANALYSTS JOURNAL /JANUARY-FEBRUARY 1988 LI 65



Table III Relative Volatility of Daily Cash and Futures Prices

Variances of Rates of Return

S&P 500 Value Line

5/3/82- 5/3/82- 8/31/86 8/31/86

Entire Time Period

Cash 0.7623 0.4781 Futures 1.4442 1.1746 F-Statistic 1.5009* 2.4568*

Exduding 10/1/79 to 9/30/82

Cash 0.7209 0.4559 Futures 1.0139 1.0443 F-Statistic 1.4064* 2.9026*

'Futures price volatility is significantly greater than cash price volatility at 5 per cent level.

the cash market by arbitrageurs. And stock index futures prices do appear to be more volatile than cash prices. Table III shows the variances of close-to-close percentage daily price changes (or daily rates of return) for both cash prices and near-month (or spot-month) stock index futures prices. Futures prices are significantly more volatile than cash prices; this is evident in Figure A as well.7 But is this volatility transmitted to the cash markets?

The Evidence on Stock Index Futures To assess the impact on stock price volatility

of stock index futures trading, we examined the volatility of the stock market both before and after the start of futures trading (April 21, 1982 for the S&P 500 contract, February 24, 1982 for the Value Line contract). We computed cash market volatility for each of the above indexes in the periods before and after the introduction of futures trading.

Determining the impact of futures contracts on cash market volatility is complicated by the monetary policy shifts that took place in 1979 and 1982. Because of these shifts, stock market volatility was significantly greater in 1979-82 than it was either before or after. Thus the calculations were made in two ways-including the 1979-82 period and excluding it. Excluding the period provides a better view of the impact of futures market trading.

We measured volatility as the variance of close-to-close percentage daily price changes (or rates of return).8 Consistent data on intraday high and low prices were not available. On January 2, 1984, for example, Standard & Poor's changed its method for calculating the high and

low prices for its 500 index. Evidence developed elsewhere for stock indexes suggests, however, that consistent high-low variance estimators, were they available, would yield conclusions similar to those based only on close-to-close variance estimators.9

Finally, it is obvious that our procedure is crude in that it does not account for factors other than the monetary regime shift that might influence daily price volatility. Unfortunately, we know of no satisfactory way to do this. Daily price movements are subject to daily changes in investors' expectations, which cannot be measured. Expectations about future price inflation, for example, can change quickly and significantly during the course of a day, as new economic news unfolds. Thus our results, based on the volatility before and after the introduction of futures, are valid only if a shift in either the information-generation process or the expectations-formation process has not coincided with the advent of futures trading.10

Table IV shows the average price volatilities for the periods for which daily data are available before and after futures trading in the two stock index contracts. Excluding 1979-82, the volatility of the S&P 500 was significantly greater before the start of futures trading. The volatility of the Value Line index showed no significant change. Neither exhibited an increase in volatility after the introduction of futures trading.

There is thus no evidence that futures trading

Table IV Variances of Rates of Return (dose-to-dose daily prices; number of observations in parentheses)

S&P 500 (A) Value Line (B) Pre-Futures

Entire Period 0.8559 0.5979 (A) 6/1/7344/20/82 (2245) (B) 1/175-2123/82 (1800)

Exduding 79-82 0.8311 0.5187 (A) 6/1173-9/30/79 (1610) (B) 1/1175-9/30/79 (1193)

Post-Futures

Entire Period 0.7783 0.5212 (A) 4121/82-12131/86 (1189) (B) 2J24/82-1231/86 (1229)

Exduding 79-82 0.7417* 0.5095 (A) 10/1/82-1231/86 (1075) (B) 10/1/82-1231/86 (1075)

*Vanance for the pre-futures period (exduding the time peniod 10/1/79 to 9/30/82) is greater than variance for the post-futures period at the 5 per cent level of significance.

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1988 ] 66



Table V Alternative Estimators of Volatility, Daily Stock Indexes (une 1, 1973 to May 18, 1987)

S&P 500 (A) Value Line (B)

Close- High- Intra- Close- High- Intra- Closea Lowb day c Closea Lowb Day c

Pre-Futures

6/1/73 to 4/20/82 (A) 0.9252

2/23/82 (B) 0.7732

6/1/73 to 9/30/79 0.9117 0.7202

Post-Futures

1983 0.8394 0.4561 1.0111 0.6745 0.2373 0.7068 (0.4919) (0.3979)

1984 0.8003 0.4382 0.9914 0.6618 0.2348 0.6895 (0.4816) (0.4192)

1985 0.6376 0.2651 0.7809 0.5129 0.1439 0.5628 (0.3534) (0.2865)

1986 0.9291 0.5755 1.1204 0.8361 0.3223 0.7525 (0.5832) (0.5725)

1986d 0.8635 0.5265 1.0928 0.7165 0.2469 0.7110 (0.5151) (0.4328)

1/1/87 to 5/18/87 1.0664 0.9747 1.4632 0.8224 0.3866 0.8818

(0.7516) (0.5445)

a. Cose-to-dose standard deviation. b. Parkinson's high-low estimator. c. Mean and (standard deviation) of ln(HIL). d. Observations on expiration days of S&P 500 futures and September 11 and 12, 1986 are excluded.

has had a long-run destabilizing effect on the stock market. If anything, volatility has been lower since the introduction of futures trading.

The Recent Increase in Volatility The latter part of 1986 and early 1987 have exhibited a sharp rise in stock market volatility. Table V reports market volatility for individual years since the beginning of futures trading in stock index contracts.

For recent years, it is possible to examine market volatility using alternative estimators of volatility, in addition to the standard close-to- dose daily price variance used in Table IV. We examined two measures of intraday volatility, as it is alleged that much of the recent volatility has been in intraday price movements, rather than in day-to-day price changes. The two measures are: (1) an efficient high-low variance estimator using intraday high (H) and low (L) prices, measured as:

[ln(Ht) - ln(Lt)]2/4 1n2,

and (2) an intraday price range estimator, repre-

sented by the mean and standard deviation of the daily percentage differences between the intraday high and low prices, measured as:

ln(Ht/Lt).

The "high-low" variance estimator was developed by Parkinson, who shows theoretically that under certain restrictive assumptions it is a more efficient estimator than the traditional close-to-close variance.11 Estimating true volatility is difficult because of the lack of continuous price observations; the dosing price is only one observation each day. The intraday "price range" estimator, while closely related to Par- kinson's high-low estimator, is provided sepa- rately because it provides a more intuitive measure of volatility.

Table V shows the alternative volatility measures for both the S&P 500 and Value Line indexes, for individual years from 1982 to 1987, as well as the close-to-close volatility measure for the pre-futures period. It is clear that, until 1986, volatility was lower in every full year since the advent of futures. Volatility began to rise in

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1988 O 67



1986 and increased even more in 1987. All measures of volatility show similar movements.12

While there is no dear explanation for the recent rise in stock market volatility, it is unlike- ly that it can be attributed primarily to futures trading. The most likely causes are the excep- tional rise in stock prices during recent months, the sharp fall of the dollar against leading cur- rencies and the persistence of significant economic problems, such as the Federal deficit and the trade imbalance.'3 Higher volatility has also occurred in the bond market and in other markets not associated with stock index futures trading.

The upswing in volatility should be interpret- ed in the context of the nearly five years of stock index futures trading that we have experienced. During most of that time, volatility was lower than it was before futures trading began. E

Footnotes 1. Of the number of studies addressing this volatil-

ity, see "The Role of Index-Related Trading in the Market Decline on September 11 and 12, 1986" (Report by the Division of Market Deregulation, U.S. Securities and Exchange Commission, March 1987).

2. After the precipitous fall in stock prices on Octo- ber 19, 1987, however, there will undoubtedly be more studies directed at the impact of portfolio insurance and program trading.

3. See H. Stoll, "Index Futures, Program Trading and Stock Market Procedures" (Paper prepared for a conference on Stock Index Futures, Colum- bia Futures Center, Columbia University, June 8, 1987).

4. For a more extensive discussion of these points see F.R. Edwards, "The Effect of Stock Index Futures and Other Financial Futures Trading on the Volatility of Cash Prices" (Paper prepared for a conference on Stock Index Futures, Columbia Futures Center, Columbia University, June 8, 1987).

5. There may be other beneficial effects of an increase in volatility due to futures trading. If a cash market is subject to monopolistic pricing prior to the advent of futures markets, for example, introducing a vehicle such as futures, through which market participants can buy and sell at competitive prices, may increase volatility but also result in prices that better reflect fundamental demand and supply conditions. In addition, futures markets tend to bring about an improvement in cash-price reportihg. Futures

exchanges make readily available daily, even intraday, futures prices. For many commodities, daily cash prices were not publidy reported prior to the advent of futures markets in the commod- ity. Futures trading thus creates a demand for better cash-market information. Investors may perceive an increase in cash price volatility simply because more frequent cash price quotations are available as a result of futures trading.

6. See, for example, J.L. Stein, "Real Effects of Futures Speculation: Rational Expectations and Diverse Precisions" (Working paper no. 88, Cen- ter for the Study of Futures Markets, Columbia University, 1984).

7. Futures and cash prices are linked by a cost-of- carry relationship and by futures/cash arbitrage. Further analysis reveals, however, that this dif- ference in (rate-of-return) volatility cannot be explained by either the volatility of observed interest rates or by the likely volatility of the expected dividend yield. Higher volatility of futures is also possible because of the significant transaction costs associated with futures/cash arbitrage. Finally, because of the lower transaction costs associated with trading in futures as op- posed to cash markets, futures prices may re- spond more often and more quickly to changes in underlying economic fundamentals. For an analysis of the relation between cash and futures stock indexes, see D.M. Modest and M. Sundare- san, "The Relationship Between Spot and Fu- tures Prices in Stock Index Futures Markets: Some Preliminary Evidence," The Journal of Fu- tures Markets 3 (1983), pp. 15-41.

8. The standard close-to-dose variance estimator of the percentage changes in daily spot prices is measured as ln(Pt/Pt-1), where Pt and Pt-1 are closing prices on successive days. The results obtained by using this measure are very similar to those obtained using other measures of volatility, such as the mean of the absolute daily percentage close-to-close price changes. In addition, because of the significant changes in the level of prices that took place over the 1973-86 period, we based our volatility measures on percentage, rather than absolute, price movements. From an invest- ment standpoint, it is obvious that comparing rates of return is more meaningful than comparing absolute (or dollar) movements.

9. See Table V. 10. A few earlier studies attempt to control for "oth-

er" factors but, in my view, fail to do so. See Edwards, "The Effect of Stock Index Futures," op. cit., pp. 26-29.

11. M. Parkinson, "The Extreme Value Method for Estimating the Variance of the Rate of Return," Journal of Business 53 (1980), pp. 61-65. Beckers has empirically compared the close-to-close vari-

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1988 [1J68



ance estimator with Parkinson's high-low estimator and concluded that Parkinson's estimator contains new informatior and is a more accurate estimator of true volatility. See S. Beckers, "Var- iances of Security Price Returns Based on High, Low and Closing Prices," Journal of Business 56 (1983), pp. 97-113.

12. For example, if monthly volatilities are calculated using the close-to-close (first column of Table V) and intraday (third column) measures for the

period 1982-86, the two measures show a correla- tion of 0.91 for the S&P 500 and 0.95 for the Value Line index.

13. Regression analyses relating monthly measures of volatility to absolute percentage price (or index) changes during a month clearly show a positive and significant relation between volatility and price movements. The greater the general price change during the month, the higher market volatility.

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