linkage between stock market volatility & derivatves

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Linkage between Stock Market Volatility and the Introduction of Index Futures in India

M P Birla Institute of Management 1

Linkage between Stock Market Volatility and the

Introduction of Index Futures in India

A DISSERTATION SUBMITTED IN PARTIAL FULFILLMENT OF

THE REQUIREMENTS FOR THE AWARD OF MBA DEGREE OF

BANGALORE UNIVERSITY.

Submitted By

Sachna Sundar

Reg.No -03XQCM6086

UNDER THE GUIDANCE OF

Sri. T.V.N. Rao

INTERNAL GUIDE

M.P.BIRLA INSTITUTE OF MANAGEMENT

ASSOCIATE BHARTIYA VIDYA BHAVAN.

BANGALORE-560001

2003-2004





CHAPTER 1

INTRODUCTION





Background of Indian Financial Markets:

Financial markets in India have been largely synonymous with the Stock

markets. There were several reasons for this. Being a largely agrarian based

economy, the farming community was a completely protected one and the socialistic

policies followed by successive governments led to the image that trading in

commodities was something that was almost “un-Indian”. Therefore, commodity-

trading exchanges were never ever encouraged.

To this day, the vast majority of the trading taking place in the different

commodity markets in the country is all dominated by forward contracts between

actual producers and wholesalers/exporters etc. Further, the Indian economy being

a closed one, foreign exchange trading was something entirely, well, foreign. We

also had some kind of protectionism in the Gold and Silver markets and there was a

ban, until recently, on any kind of export or import of these metals. Therefore, this

market too could not develop like their counterparts in the other parts of the world.

This left only the Stock Markets as an arena where man could express one of his

natural instincts to trade. The rapid industrialization and the continued socialistic

policies of the seventies led to the FERA dilution which was the major impetus to this

market, led to greatly increased public interest in the markets. The era of the IPO

(initial public offering) was born and the stock market became the place for

investment.

As the markets grew, slowly, a need for some kind of a hedging mechanism

was felt by the players of the stock markets, now that the game had gotten a lotbigger than it ever was. The BSE Index during this period had risen from the sedate

200-300 ranges of the early eighties to 4500 in the mid nineties. This was a huge

rise and the decline that set in from there was also much, much larger than what had

been experienced by the players until then. By then the Mutual Fund industry had

also got established in the Indian markets.





The only known hedging mechanism in the market was a system known as

“badla”. This system functioned well when stocks had to be sent for transfer and the

financier was protected from any adverse stock price moves by taking a position in

the budla market. This system was imperfect but served the purposes of most

traders and financiers. But since mutual funds were not allowed to participate in this

market, it remained the fiefdom of brokers and traders. This led to periodic abuses of

the system by different brokers and market operators, the most recent one being the

manipulation of the budla market at the CSE by Ketan Parekh and his coterie.

SEBI, which had come into existence by 1993, was slowly flexing its muscles

over the years, trying to bring some kind of discipline into the market and relaxing

the stranglehold that the brokers and operators had over the stock markets. With

every passing year, SEBI gathered more and more teeth and finally, in the year

2000, they managed to get the exchanges to start a Futures and Options segment.

The markets started trading in Futures in 2000 and in 2001, the options market also

began. This was a landmark event in the evolvement of our financial markets to

world standards.

Financial Derivatives Market and its Development in India:

Financial markets are, by nature, extremely volatile and hence the risk factor

is an important concern for financial agents. To reduce this risk, the concept of

derivatives comes into the picture. Derivatives are products whose values are

derived from one or more basic variables called bases. These bases can be

underlying assets (for example forex, equity, etc), bases or reference rates. For

example, wheat farmers may wish to sell their harvest at a future date to eliminate

the risk of a change in prices by that date. The transaction in this case would be the

derivative, while the spot price of wheat would be the underlying asset.





Development of exchange-traded derivatives:

Derivatives have probably been around for as long as people have been

trading with one another. Forward contracting dates back at least to the 12th centuryand may well have been around before then. Merchants entered into contracts with

one another for future delivery of specified amount of commodities at specified price.

A primary motivation for pre-arranging a buyer or seller for a stock of commodities in

early forward contracts was to lessen the possibility that large swings would inhibit

marketing the commodity after a harvest.

Introduction to Index:

An Index is used to summarize the price movements of a unique set of goods

in the financial, commodity, forex or any other market place. Financial indices are

created to measure price movements of stocks, bonds, T-bills and other type of

financial securities. More specifically, a stock index is created to provide investors

with the information regarding the average share price in the stock market. Broad

indices are expected to capture the overall behavior of equity market and need torepresent the return obtained by typical portfolios in the country.

• The primary function of a stock index is to serve as a barometer of the equity

market. The ups and downs in the index represent the movement of the

equity market. Any investor can look at the performance of the index to find

out how the equity market is doing.

• The availability of an index lends itself to forecasting of the market conditions

by technical analyst. Technical analysts believe that historical share price

movements can be used to predict the future price movements. They use the

stock index data to forecast which direction the market is likely to move in

near future.





• The most important use of an equity market index is as a benchmark for a

portfolio of stocks. All diversified portfolios, belonging either to retail investors

or mutual funds, use the common stock index as a yardstick for their returns.

• Finally Indices are useful in modern financial applications of derivatives.

Indices serve as the underlying for futures and options products and also for

the Exchange Traded Funds.

SENSEX:

SENSEX is India's first Index compiled in 1986. It is a basket of 30 constituent

stocks representing a sample of large, liquid and representative companies. The

base year of BSE-SENSEX is 1978-79 and the base value is 100. The index is

widely reported in both domestic and international markets through print as well as

electronic media.

Due to its wide acceptance amongst the investors, SENSEX is regarded to be

the pulse of the Indian stock market. All leading business newspapers and the

business channels report SENSEX, as it is the language that all investors

understand.

As the oldest index in the country, it provides the time series data over a fairly

long period of time (from 1979 onwards) to be used for various research purposes.

The Index Cell of the exchange is responsible for the day-to-day maintenance of the

index within the broad index policy set by the Index Committee. The Index Cell

ensures that the SENSEX and all other BSE indices maintain their benchmark

properties by striking a delicate balance between frequent replacements in index

and maintaining its historical continuity.





NIFTY:

The Nifty is relatively a new comer in the Indian market. S&P CNX Nifty is a

50 stock index accounting for 23 sectors of the economy. It is used for purposes

such as benchmarking fund portfolios; index based derivatives and index funds. The

base period selected for Nifty is the close of prices on November 3, 1995, which

marked the completion of one-year of operations of NSE's capital market segment.

The base value of index was set at 1000.

S&P CNX Nifty is owned and managed by India Index Services and Products

Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is a specialized

company focused upon the index as a core product. IISL have a consulting and

licensing agreement with Standard & Poor's (S&P), who are world leaders in index

services.

What are Derivatives?

The term "Derivative" indicates that it has no independent value, i.e. its value

is entirely "derived" from the value of the underlying asset. The underlying asset can

be securities, commodities, bullion, currency, live stock or anything else. In other

words, Derivative means a forward, future, option or any other hybrid contract of pre

determined fixed duration, linked for the purpose of contract fulfillment to the value of

a specified real or financial asset or to an index of securities.

With Securities Laws (Second Amendment) Act, 1999, Derivatives has been

included in the definition of Securities. The term Derivative has been defined in

Securities Contracts (Regulations) Act, as:





A Derivative includes:

SA security derived from a debt instrument, share, loan, whether secured or

unsecured, risk instrument or contract for differences or any other form of

security;SA contract which derives its value from the prices, or index of prices, of

underlying securities.

Types of Derivatives:

Forwards:

A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price.

Futures:

A futures contract is an agreement between two parties to buy or sell an asset

at a certain time in the future at a certain price. Futures contracts are special types

of forward contracts in the sense that the former are standardized exchange-tradedcontracts

Options:

Options are of two types - calls and puts. Calls give the buyer the right but not

the obligation to buy a given quantity of the underlying asset, at a given price on or

before a given future date. Puts give the buyer the right, but not the obligation to sell

a given quantity of the underlying asset at a given price on or before a given date.

Warrants:

Options generally have lives of upto one year; the majority of options traded

on options exchanges having a maximum maturity of nine months. Longer-dated

options are called warrants and are generally traded over-the-counter.





LEAPS (Long-Term Equity Anticipation Securities):

The acronym LEAPS means Long-Term Equity Anticipation Securities. These

are options having a maturity of upto three years.

Baskets:

Basket options are options on portfolios of underlying assets. The underlying

asset is usually a moving average or a basket of assets. Equity index options are a

form of basket options.

Swaps:

Swaps are private agreements between two parties to exchange cash flows in

the future according to a prearranged formula. They can be regarded as portfolios of

forward contracts.

The two commonly used swaps are:

• Interest rate swaps: These entail swapping only the interest related cash flows

between the parties in the same currency.

• Currency swaps : These entail swapping both principal and interest between the

parties, with the cash flows in one direction being in a different currency than those

in the opposite direction.

Swaptions:

Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. Rather than

have calls and puts, the swaptions market has receiver swaptions and payer

swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer

swaption is an option to pay fixed and receive floating.





Structure of Derivative Markets in India

Derivative trading in India takes can place either on a separate and

independent Derivative Exchange or on a separate segment of an existing StockExchange. Derivative Exchange/Segment function as a Self-Regulatory

Organization (SRO) and SEBI acts as the oversight regulator. The clearing &

settlement of all trades on the Derivative Exchange/Segment would have to be

through a Clearing Corporation/House, which is independent in governance and

membership from the Derivative Exchange/Segment.

Types of Derivative Contracts Permitted by SEBI:

Derivative products have been introduced in a phased manner starting with

Index Futures Contracts in June 2000. Index Options and Stock Options were

introduced in June 2001 and July 2001 followed by Stock Futures in November

2001.

Minimum Contract Size:

The Standing Committee on Finance, a Parliamentary Committee, at the time

of recommending amendment to Securities Contract (Regulation) Act, 1956 had

recommended that the minimum contract size of derivative contracts traded in the

Indian Markets should be pegged not below Rs.2 Lakhs. Based on this

recommendation SEBI has specified that the value of a derivative contract should

not be less than Rs.2 Lakh at the time of introducing the contract in the market.

The Lot Size of a Contract:

Lot size refers to number of underlying securities in one contract. Additionally,

for stock specific derivative contracts SEBI has specified that the lot size of the





underlying individual security should be in multiples of 100 and fractions, if any,

should be rounded of to the next higher multiple of 100. This requirement of SEBI

coupled with the requirement of minimum contract size forms the basis of arriving at

the lot size of a contract

For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the

minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands

to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

SEBI Amendment to Stipulations on Lot Size:

While the Legislative body stipulated the minimum contract size in terms of

value (Rs.2 Lacs), the system of standardising securities trade in Lots, had a

multiplying effect, on the minimum value of a contract, when the prices of the

premium Scrips started appreciating over time. BSE Index (Sensex) which was less

than 3000 at that time swelled to nearly 6500 presently. As the value of individual

scrips increased, smaller number of such scrips would be sufficient to cover the

minimum contract value of Rs.2.00 Lacs prescribed by the Standing Committee of

the Parliament. But stipulating a fixed number of shares as the lot in many cases

swelled the value of the contract to Rs.5 Lacs and even more in many cases. This

brought derivatives trading beyond the scope of the small investor.

Considering the fact SEBI revised its stipulations regarding Lot size, but

retaining the minimum contract value at Rs.2 Lacs and issued a press release on

07.01.2004 stating:

“It has been noticed that in several derivative contracts the value hasexceeded Rs.2 lakh. In such cases it has been decided to reduce the value of the

contract to close to but not less than Rs.2 lakh by using an appropriate lot size /

multiplier which could be half or 50%. The exchanges could determine any other lot

size / multipliers to keep the contract size of derivatives close to Rs.2 lakh, but in any

case not less than Rs.2 lakh. The exchanges would be able to reduce the contract





size of a derivative contract by submitting a detailed proposal to SEBI and after

giving at least two weeks prior notice to the market. For each index there may be a

different multiple for determining the price of the futures contract.”

For example, the S&P 500 index is one of the most widely traded index

futures contracts in the U.S. Often stock portfolio managers who want to hedge risk

over a certain period of time will use the S&P 500 index future to do so. By shorting

these contracts, stock portfolio managers can protect themselves from downside

price risk of the broader market. However, by using this hedging strategy, if perfectly

done, the manager' s portfolio will not participate in any gains on the index; instead

the portfolio will lock in gains equivalent to the risk-free rate of interest.

Alternatively stock can use index futures to increase their exposure to

movements in a particular index, essentially leveraging their portfolio.





AN INTRODUCTION TO FUTURES

For a trade to take place, what you need is two people- one with some goods

to sell and the other to buy it. The process of the trade will consist of both theseparties expressing their individual interests- one to buy and the other to sell – and

then they get into an auction process so as to decide the price. Once there is an

agreement on the price, the two shake hands and a transaction is complete. Where

multiple buyers and sellers congregate and multiple trades begin to occur, is called a

market. There are two ways that a trade can take place. One, the goods are

physically exchanged for money (like in a retail shop) or two; there could be a

transaction in a “promise” to deliver the goods at a future point of time for a price

agreed upon in the present.

This kind of transaction was the norm where the goods were expected to

arrive or be ready for shipment after a while – such as in Crops or commodities that

were imported or exported from other lands. The people dealing in such items would

be either the producer of it or a consumer of it. For example, a wheat farmer would

be quite interested in ensuring that he gets a good price for his crop – when he is

ready with it – from the bread manufacturer (who is the consumer of his product).

In the same fashion, the bread manufacturer is equally interested in tying up

good and consistent supply of wheat so that he can produce his goods (i.e. bread)

uninterrupted. This need of both parties is met by the formation of the “Forward

Market” or a market that deals in the present for value to be settled at some point of

time in the future.

Such Forward markets have existed ever since trade began. They had some

imperfections within them and this led the traders to form what came to be known

subsequently as the Futures markets.





What is a Futures Contract?

Futures Contract means a legally binding agreement to buy or sell the

underlying security on a future date . Future contracts are the organized/standardized

contracts in terms of quantity, quality (in case of commodities), delivery time and

place for settlement on any date in future. The contract expires on a pre-specified

date which is called the expiry date of the contract. On expiry, futures can be settled

by delivery of the underlying asset or cash. Cash settlement entails paying/receiving

the difference between the prices at which the contract was entered and the price of

the underlying asset at the time of expiry of the contract.

Futures Contract Details:

The Index futures commenced trading in June 2000. The exchanges

commenced Options trading in June 2001 with options on Index and in July 2001

with options on individual stocks. The sensex and nifty are the two designated

indices for Futures and Options trading. 31 leading stocks have been designated for

options trading. These have been selected on the basis of some stringent conditions

and parameters laid down by SEBI.

The Sensex futures contract trades with a 50 multiple while the Nifty contract

has a 200 multiple. Translated, this means that one futures contract of the Sensex

would mean 50 Sensex while one Nifty contract would get you 200 Nifty. Hence

every point move in the sensex would mean a 50-point change in the value of the

contract and 200 in the nifty contract. Or, in other words, if one is long index futures,

for every one point move of the sensex, one would get a profit or loss of Rs.50 and it

would be Rs.200 for the nifty.





It should be realized that derivative products have a short life. They are

designated by the time when they are said to “expire”. That is, the date of expiry is

the last day of trading. After that date, a new contract has to be entered into. The

exchanges have standardized the life of the contracts on both futures and options to

three months. We have therefore futures and options on indices as well as stocks for

the current month and the next two months. In the jargon, they are referred to as the

Near month, the mid month and the far month contracts. Hence we would have July

Nifty future, August Nifty and September Nifty (or Sensex) at the moment as the

three contract months trading.

What are Index Futures Contracts?

Futures contract based on an index i.e. the underlying asset is the

index, are known as Index Futures Contracts . For example, futures contract on

NIFTY Index and BSE-30 Index. These contracts derive their value from the value of

the underlying index.

An index in turn derives its value from the prices of securities that constitute

the index and is created to represent the sentiments of the market as a whole or of a

particular sector of the economy (Sectoral Index).

By its very nature, index cannot be delivered on maturity of the Index futures

contracts therefore, these contracts are essentially cash settled on Expiry.





Types of Players: The Participants in a Derivatives Market:

The market is composed of all types of players with all kinds of strategies and

desire for the end outcome. While everyone is engaged in either buying or selling, it

is motive or the strategy behind the buying or selling that differentiates the players.

Accordingly, we can make the following classifications.

SSpeculators: They use futures and options contracts to get extra leverage in

betting on future movements in the price of an asset. They can increase both

the potential gains and potential posses by usage of derivatives in a

speculative venture.

SHedgers: They use futures or options markets to reduce or eliminate the risk

associated with price of an asset.

SArbitrageurs: They are in business to take advantage of a discrepancy

between prices in two different markets. If, for example, they see the futures

price of an asset getting out of line with the cash price, they will take offsetting

positions in the two markets to lock in a profit.

1) Traders or Speculators:

They have a definite view about the directionality of the market for the future.

Hence they take up positions that will benefit them from the movement of the

underlying. In the futures markets, traders would take up long positions or buy the

futures at current rates with an expectation that it would move up in the coming days

and give them profits before the contract expires. If their view were bearish, then

they would sell the futures contract at current prices and expect it to decline as the





market goes lower and then would buy it back and make a profit out of the

difference. This process is called short selling.

In the options markets, speculators would buy Call options (the right to buy) if

they felt the market would rise or buy Put options (the right to sell) if they felt the

market would decline. They can then either hold the position until expiry or they

could square off the deal if some profits are available before the expiry date. The

difference between the purchase and sale price of the future or the option contract

would determine the profit or loss in the transaction.

For example, if one is bullish on the market, one can buy an August Future

which, say, is currently quoting at 1065 (current index level is 1060) if one expects

that the index would be moving up by August. If this supposition is correct and the

index moves up to, say, 1100, the August futures would be salable around 1105 or

so. Thus the buyer of the future contract would net a gain of about 40 points less the

transaction costs. Since each point move on the nifty index is equal to Rs.200, this

would be a profit of Rs.8000 on every contract of nifty that is purchased. If one is

bearish on the nifty and thinks that the level of nifty in September would be 1000,

then one can sell the September future contract currently trading at 1070. If the view

is correct and the nifty level in September is indeed 1000, then the September future

contract by that time would also have declined to around 1005 or so. One can then

buy back what is sold and net a gain of 65 points amounting to Rs.13000 per

contract. Of course, if one is wrong in the view and the market rises, say to 1120 by

September, then the contract would be trading around 1125 and one would then

incur a loss of 55 points or about Rs.11000 per contract.

2) Hedgers:

This is one of the most common usages of the futures and options contracts.

This is done by players who hold stocks, like Mutual Funds, and who would like to

protect the value of the portfolio during the times when the market is bearish.





Typically, they would look to participate in the futures-options markets during bearish

times. If the market were expected to fall, then a mutual fund manager would seek to

sell the Index future of a value equivalent to his portfolio. Why should one do this?

Because the law relating to mutual funds requires that the money raised should be

deployed in equities up to a certain minimum percentage.

Thus, a fund would always remain invested to that extent and only the

balance portion would be held in non-equity instruments. If the market falls, the fund

would then take a hit in the values of its holding. By selling index futures and buying

them back at a later, lower price, the fund has recouped its losses on the equity side

with a profit made on the futures trade. Thus the value of the fund is saved (to a

large extent) from eroding. This protects the Net Asset Value (NAV) of the fund and

thereby the investors in that mutual fund are also protected from erosion of their own

net worth.

Alternatively, the fund manager can also buy Puts on the index or the

individual stocks that he holds and thereby participate in the decline of the market

without selling out his holding. Again, the loss in equities value is made up by the

profits in the Put options.

It is to be noted here that Hedging does not make profits. It only contains the

losses.

3) Arbitragers:

These are set of players who try to take advantage of mispricing that

periodically occur in the market due to different sets of reasons. There could be a

difference in pricing between the underlying asset and what is known as the “fair

value” of the future instrument (either Futures or Options). There could be a

mispricing between different futures instruments themselves owing to changes in

volatility of the market or temporary supply-demand changes.





There are multiple reasons why mispricing will occur. Arbitragers keep a keen

watch on the prices and take advantage of the situation by buying and selling the

two instruments simultaneously to lock in the difference. For example, if the current

index level is 1060 and the fair value of July Nifty is 1080 but it is currently quoting at

1090, then an arbitrager would quickly sell the future contract at 1090 and buy the

cash index at 1060. This is because he sees that the correct spread between the

two should be 20 points while currently it has expanded to 30 for some reason. He

will then square off the transaction when the nifty returns to the “normal” spread of

20 points and thereby net a profit of 10 points. Similarly, one can also spot the

mispricing in option contracts and seek to profit from this. The trading of this kind is

almost a risk free venture but requires a keen eye and quick action. Arbitragers

impart a great amount of liquidity to the system.

The Need for Derivative Markets:

The word derivative means “derived from” or an “offshoot of” some other item.

The need for derivative products arose out of the basic need to hedge or control

risks in financial trades. The futures markets evolved out of business people’s need

to transfer the risk of carrying inventory to the speculators who were willing to bear

that risk, hoping to profit by a gain in the value of the commodity or stock. Before

proceeding further, therefore, it is necessary to understand the nature of risk. In the

stock markets, there are two kinds of risks:

The stock related risk – that which relates to the performance of the

company, its industry, and the market related risk – that which is connected with

factors other than the company but which impact the market as a whole.

While it is agreed that most of the stocks purchased by investors and mutual

funds would be (or should be) as a result of adequate research into the

fundamentals of the stock and its industry, it would be very difficult to account for all





the factors that go to affect the market as a whole. The number of variables, which

affect the market as a whole, are too numerous even to list. Hence, any stock

positions carries with it an element of the market as, being a part of the market, it

would represent the entire market as a microcosm. If one wanted to have a situation

where the outcome of the stock’s price was a function of its individual performance

within that industry alone, then it is obvious that there has to be one way of

eliminating the risks associated with the market as a whole. This was done through

the use of financial futures and options.

Hence, the concept of a derivative product on the stocks and indices (and in

the rest of the world, commodities and currencies) arose with an idea of shifting the

risk to people who were willing to accept them. Every market needs an element of

speculation. It is undeniable that speculation intrinsic of man’s nature. But it plays a

very useful function in the markets by increasing or providing the much needed

liquidity, without which, most markets would become quite volatile and price stability

a mirage. Hence, in order to encourage the flow of volumes, financial re-engineering

in the form of Futures and Options on stocks and indices were invented.

Economic Functions Performed by Derivatives:

1. They help in transferring risks from risk averse people to risk oriented people

2. They help in the discovery of future as well as current prices

3. They catalyze entrepreneurial activity

4. They increase the volume traded in markets because of participation of risk

averse people in greater numbers

5. They increase savings and investment in the long run





Economic Relevance of Futures Markets:

The most important role that the futures markets perform is in aiding the

process of proper price discovery. Since several different types of players areengaged in trading the futures markets with different intentions, it leads to a correct

pricing of the asset. This has important fall out, especially in the commodity and

currency markets. It prevents incorrect extension of trends that would be harmful to

the general public and thereby leads to greater market efficiency.

The presence of a larger number of tradable instruments also leads to a more

complete market, one where every type of player can have the maximum number of

features which will permit him to participate to the fullest extent in the markets. The

proper design of the futures products and the framework of trading help to contain

the risks in investments for different players. This leads to a more reliable and longer

lasting system.

Factors Driving the Growth of Financial Derivatives:

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international

markets,

3. Marked improvement in communication facilities and sharp decline in their

costs,

4. Development of more sophisticated risk management tools, providing

economic agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and

returns over a large number of financial assets leading to higher returns,

reduced risk as well as transactions costs as compared to individual financial

assets.





Summary:

The advent of the futures markets in India is a welcome addition to the

number of instruments that is currently available to the individual trader and investoras well as the institutional players. One need no longer bemoan the lack of hedging

facilities in the market and this is one of the most bullish developments for the long

term. The Indian stock markets can now begin attracting entirely newer set of

players who were hitherto hesitant to enter the stock markets because of the

absence of risk containing measures. The world over, the experience has been that

the cash market has multiplied several fold with the introduction of the Futures

markets, particularly, options. The same may be expected to happen in India too.

We are therefore set for very exciting times ahead of us in the markets. The entire

face of the stock markets as we knew it is set to change. Truly, we are now about to

catch up with the rest of the world.

Due to the introduction of index futures, the stock market volatility gets

affected. This is an attempt to study the impact of allowing the index futures trading

on the stock market by using one of the measures of volatility. The method is based

on close-to-close price, to measure volatility. This also attempts to find out how the

futures market volatility affects the underlying stock market volatility. The stock

market gets more matured, and the volatility in the stock market gets reduced to a

considerable extent by the introduction of index futures in India.

The Indian capital market has witnessed a major transformation and structural

change during the past one decade, as a result of the ongoing financial sector

reforms since 1991, in the wake of policies of liberalization and globalization. The

major objectives of these reforms have been to improve the market efficiency,

enhance transparency, check unfair trade practices, and bring the Indian market up

to international standards.





As a result of the reforms, several changes have also taken place in the

operations of the secondary markets such as automated on-line trading in

exchanges, enabling trading terminals of the National Stock Exchange (NSE) and

Bombay Stock Exchange (BSE) to be available across the country, and making the

geographical location of an exchange irrelevant reduction in the settlement period,

opening of the stock markets to foreign portfolio investors etc. In addition to these

developments, India is perhaps one of the real emerging markets in the South Asian

region that has introduced derivative products on two of its main existing exchanges

in June 2000, to provide tools for risk management investors. These had, however,

been a considerable debate on the question of whether derivatives should be

introduced in India or not.

The LC Gupta Committee on Derivatives, which examined the whole issue in

details, had recommended the introduction of stock index futures in the first place in

1997.The preparation of regulatory framework for the operations of the derivatives

contracts took another three and a half years more, as it required not only an

amendment in the securities contracts (Regulation) Act, 1956 but also the

specification of the regulations for such contracts.

Finally, the Indian capital market saw the launching of index futures in June

2000 on two of the existing exchanges, viz., BSE and the NSE. A year later, options

on index were also introduced for trading on these exchanges. Later, stock options

on individual stocks were launched in July 2001.The latest product to enter in to the

derivative segment on these exchanges is contracts on stock futures in November

2001.Thus,with the launch of stock futures, a derivative product in India seems to be

complete.





RESEARCH OBJECTIVES

The Objectives of the study are:

STo find out the impact of introduction of index futures on the stock market

volatility in India

STo find out how the futures market volatility affects the underlying stock

market volatility.

HYPOTHESES

The study tests the following hypotheses:

The Volatility of the underlying stock market has not changed after the

introduction of index futures. In statistical terms, hypotheses can be specified as

under:

H0: (before) � (after)

H1: (before) = (after)

There is no significant difference between the relative volatility of the

underlying stock market and the futures market.

In statistical terms, the hypotheses are specified as under:

H0: (Index Futures) � (Spot Index)

H1: (Index Futures) = (Spot Index)





Significance of the study:

Not much of research has been undertaken in this area .This

study helps in understanding how the introduction of Index Futures has affected theIndian stock market.

Among all the innovations that have flooded the international

financial markets, financial derivatives occupy the driver' s seat.Derivatives are

financial instruments whose values depend on the values of underlying assets.

So it is important to study the effect of Index Futures and how it

affected Indian Stock Market





CHAPTER 2

REVIEW OF LITERATURE





RREEVVIIEEWW OOFF LLIITTEERRAATTUURREE::

The introduction of equity and equity index derivative contracts in Indian

market has not been very old but today the total notional trading values in

derivatives contracts are ahead of cash market. On many occasions, the derivatives

notional trading values are double the cash market trading values. Given such

dramatic changes, we would like to study the behaviour of volatility in cash market

after the introduction of derivatives.

Impact of derivatives trading on the volatility of the cash market in India has

been studied by Thenmozhi (2002), Shenbagaraman (2003), Gupta and Kumar

(2002) Gupta and Kumar (2002) did find that the overall volatility of underlying

market declined after introduction of derivatives contracts on indices. Thenmozhi

(2002) reported lower level volatility in cash market after introduction of derivative

contracts. Shenbagaraman (2003) reported that there was no significant fall in cash

market volatility due to introduction of derivatives contracts in Indian market.

Raju and Karande (2003) reported a decline in volatility of the cash market

after derivatives introduction in Indian market. All these studies have been done

using the market index and not individual stocks.

These studies were conducted using data for a smaller period and when the

notional trading volume in the market was not significant and before tremendous

success of futures on individual stocks.

Today derivatives market in India is more successful and we have more than

3 years of derivatives market. Hence the present study would use the longer period

of data to study the behaviour of volatility in the market after Index Futures was

introduced. The study uses S& P CNX Nifty close to close values for analysis.





CHAPTER 3

METHODOLOGY





METHODOLOGY:

The data employed in the study consists of daily prices of major stock market

index viz., the S&P CNX Nifty Index (henceforth Nifty Index) for a four and a halfyear period from June 8, 1998 to December 31, 2002.For this index, two sets of

prices were used. These were daily open and close.

Likewise, open and close prices were used for a period of one and a-half

year period i.e., from June 12, 2001 to December 31, 2002 for the Nifty Index

Futures contracts. The necessary data have been collected from the derivative

segments of this exchange.

The study has used measure of volatility.

In the first place, the daily returns based on closing prices were computed

using question:

Rt = ln (C t /C t-1)

Where,

C t and C t-1 are the closing prices on day t and t-1 respectively.

R t represents the return in relation to day t.





Next, compute the variance of this return series to understand the inter –trade

volatility by using the equation:

T _

[2 = �5 t – R ) 2 / T -1

T =1

Where,

_ T

R = � (R 1) / T

T =1

The impact of introduction of futures contracts on the underlying stock market

has been examined by comparing the daily volatility measured by standard

deviation), before and after futures introduction in terms of measures based on

(Ct/Ct-1).

EMPIRICAL RESULTS:

The results pertaining to the question of whether or not there has been an

impact of introduction of index futures on the volatility of the underlying stock market,

for the index i.e., Nifty Index has been discussed in this research. Later, the results

relating to the relative volatility of index futures market and spot indices are





presented and discussed. Here again, the results are discussed separately for the

futures and the index.

IMPACT OF INTRODUCTION OF INDEX FUTURES ON STOCK

MARKET VOLATILITY:

The research now present and discuss the empirical results pertaining to the

impact of introduction of index futures contracts on the stock market volatility in

respect of both the indices.

Effect of Introduction of Index Futures on Nifty Index:

Tables 1 show the effect of introduction of index futures contracts on Nifty

Index in respect of ln (Ct/Ct-1), for several periods. Interestingly, the volatility of the

market seems to have declined post introduction of index futures for all the periods,

in respect of both these measures. In fact, expecting for the one-month period, theresults indicate that post introduction volatility of the Nifty Index has declined.

Though, for the one-month period too, the volatility seems to have declined, but it

was not found to be statistically significant. One possible explanation could be that

the market operators took time to understand the intricacies of the operations of the

futures market.

This is clearly reflected by the low level of futures market’s activities, both in

terms of number of contracts and the volume of trades done in the month of June

2000.





Table 1

Effect of Introduction of Index Futures on Nifty

index

Ln (Ct / Ct-1) S. D. Before S. D. After

1 Month 0.02112554 0.012041698

2 Months 0.026118695 0.015133876

3 Months 0.026565963 0.014491243

6 Months 0.023574876 0.015735007

9 Months 0.021500522 0.015705916

12 Months 0.019974151 0.017032926

15 Months 0.020676 0.015793804

18 Months 0.020321 0.016246764

24 Months 0.020097 0.016142





RELATIVE VOLATILITY: INDEX FUTURES AND SPOT MARKETS:

The research shall now present and discuss the results of relative volatility of

futures and spot market in respect of both the indices, to see whether index futuresare more (less) volatile than the underlying spot index.

Daily Price Volatility: Nifty Index Futures and Nifty Index

Empirical results relating to relative volatility of Nifty Index futures and Nifty

Index Spot index are given in Tables3; Table gives the daily volatility for each monthfrom June 2001 to December 2002 for the near month Nifty Index Contracts, and for

the spot market on daily basis using the close-to-close volatility measure given by ln

(Ct/Ct-1).

In terms of the measure, though volatility of near month futures contracts is

higher in respect of 8 months out of 19 months, none of them, however, is

statistically significant. In fact, on comparison, volatility of futures and the spot

market does not seem to be different for any of the months studied. Similarly, for the

total period, the volatility for the markets is significantly different. Interestingly, here

volatility for the spot index was found to be higher in respect of 14 months out of 19

months. However, only in respect of three months viz., June 2001, November 2001

and August 2002, the spot index volatility was significantly higher than the near

month futures contracts.

However, for the overall period, the volatility for the market is not statistically

significant. .Here, too, the spot volatility was significantly higher than the near month

futures contracts for only for three months viz., June 2001,November 2001 and

August 2002.





Table 2:Daily Price Volatility :Nifty Index Futures and Nifty Index

Ln (Ct/Ct-1) Observations S.D. of Nifty Index

Futures

S.D. of Nifty

Index

Year 2001

June 13 0.011814698 0.012580483

July 19 0.00975337 0.010228951

August 22 0.01054 0.005166508

September 19 0.02054 0.026272497

October 17 0.012624686 0.012219879

November 22 0.1372 0.012021396

December 19 0.014853755 0.012497081

Year 2002

January 19 0.01022 0.010062354

February 16 0.01130 0.015266788

March 20 0.03039 0.009197554

April 17 0.02325 0.011127738

May 22 0.00856 0.013542627

June 20 0.01170 0.011354597

July 19 0.00987 0.009863281

August 20 0.00413 0.008643585

September 19 0.02703 0.00734145

October 18 0.01225 0.008458243

November 20 0.01259 0.006921238

December 17 0.01139 0.009246714

Total Period 358





In sum, the results reported here indicate that the daily volatility by month for

the stock market and the futures market is not significantly different during the study

period. However, the overall volatility for the two markets was not found to be

significantly different from each other.

Analysis Of Variance (ANOVA)

sample n x bar x grand (x bar –xgrand)

sqr(xbar-x grand)

n*(sqr(xbar-x

grand)

1 502 0.00082 0.000133 0.000687 4.71E-07 0.000237

2 502 -0.00055 0.000133 -0.00068 4.67E-07 0.000235

sum 0.000471

variance 0.000471

variance 0.000319

f ratio 1.47542

f tab 3.84

f tab > f ratio so null hypothesis is accepted





Limitation of the Study:

As stock market volatility is effectively depicted with the help of GARCH

model the limitation of the study is the absence of the usage og this particular Model.





CHAPTER 5

ANALYSIS AND DISCUSSION





The research gives the daily volatility for each month from June 2000 to

December 2001 for the near month index futures contracts, and for the stock market

using close-to- close volatility measure given by ln (Ct/Ct-1). In general, volatility of

near month futures contracts and the spot market does not seem to be different for

most of the months studied.

It is clear from the results obtained that the standard deviation of the NSE

index i.e. Nifty has been reduced after the introduction of the index futures. This

shows that volatility of Nifty has been reduced after the introduction of the index

futures.

Even though index futures have been introduced in June 2002, market took a

little time to understand the integrities of the index futures. Taking this into

consideration the data has been chosen from June 2001 to December 2002 in order

to accommodate the possible and obvious changes in the market conditions.

As the volatility of the index and the index futures are closely related there is

no much change in the volatility of both.

In sum, the results reported here indicate that the daily volatility by month for

the stock market and the futures market is not different during the study period.





CHAPTER 6

CONCLUSION





CONCLUSION:

The attempt is made to examine the impact of introduction of index futures on

stock market volatility. Further, it has also examined the relative volatility of spot

market and futures market. The study utilized daily price data (open and close) of

the main index from the Indian stock market viz., S&P CNX Index for the four-and-

a-half year period from June 1998 to December 2002.Similar data for a one-and-a-

half year period from June 9, 2001 to December 31, 2002 have also been used for

Nifty index Futures contracts.

The study has used a measure of volatility first is based upon close-to-close

prices. The empirical results reported here indicated that the overall volatility of the

underlying stock market has declined after the introduction of the index futures on

both the indices, in terms of both the measures i.e., ln (Ct/Ct-1).There is no

conclusive evidence, which suggests that futures volatility is higher (lower) in

comparison to the underlying stock market for both the indices, in terms of all the

three measures used for estimating volatility.

In fact, there is some evidence that the futures volatility is lower in some

months, in comparison to the underlying stock market for both of these indices.





CHAPTER 7

REFERENCES




References:

1.”Futures-Options and the Investor “ by Dr.C.K.Narayan

2. “Introduction to Futures and Options Markets” by John Hull

3. “Complete guide to Futures markets” by Jack Schwaeger.

Websites:

Swww.nseindia.com

Swww.bse.com

Swww.cboe.com

Swww.numa.com

Swww.investopedia.com

linkage between stock market volatility & derivatves

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