CFA Institute

Stock Index Futures and Cash Market VolatilityAuthor(s): Edwin D. Maberly, David S. Allen and Roy F. GilbertSource: Financial Analysts Journal, Vol. 45, No. 6 (Nov. - Dec., 1989), pp. 75-77Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479281 .

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when the entities are not only independent, distinct and fundamentally different cash-generating centers, but where legal and contractual barriers restrict the free flow of cash between the entities. Individual, non-consolidated cash flow statements are arguably preferable, even if the case for consolidated balance sheets and income statements is persuasive. The FASB did not consider a pronouncement that would treat the three statements differently, or require sup- plementary disclosure of individual cash flow state- ments.

But arguments for consolidated balance sheets and income statements may not even be persuasive. One of the results of our study shows that consolidation increases the level of current ratios. Is that result meaningful? The current ratio is potentially useful for comparing the cash inflow prospects represented by current assets with the cash outflow prospects repre- sented by current liabilities. But the current assets of finance subsidiaries are often not available to satisfy the current liabilities of the parent; comparison of consolidated current assets and liabilities is thus meaningless.

Our study also demonstrates that consolidated balance sheets are more stable. But does this mean that creditors bear less risk of default? Again, the answer is no to the extent that the assets and liabili- ties of the entities are not fungible and readily ex- changeable.

Consolidated financial statements may obscure the priority of various creditors' claims. Through direct or 'moral' guarantees (e.g., income maintenance agree- ments) parents' assets may be available to satisfy subsidiary obligations. The risk of default may thus be lower for creditors of the captive finance subsid-

iary. Default risk at the parent level, however, may be obscured under consolidation.

To decide that all majority-owned subsidiaries should be consolidated and that all previously man- dated disclosures should continue to be made (with none added or deleted) appears ritualistically simplis- tic. When will the FASB realize that a complex world is not made simple by describing it as such? And what has become of the scope of auditors' duties and responsibilities? One gets the impression from the recent history of FASB pronouncements that auditor power over client lack of respect for the intent and spirit underlying generally accepted accounting prin- ciples is essentially nil. The FASB's apparent strategy succeeds in relieving auditors of the pressure of policing client abuses of GAAP, but it renders their task less meaningful. Financial analysts could use fewer pronouncements like SFAS 94 and closer audi- tor scrutiny of accounting practices with the objective of bringing accounting form nearer to a reflection of economic substance. The evidence suggests that ac- counting standard setting is moving in the wrong direction and picking up speed.

Footnotes 1. American Banker, June 1987. 2. See, for example, J. Livnat and A. Sondhi, "Fi-

nance Subsidiaries: Their Formation and Consoli- dation," Journal of Business Finance and Accounting, Spring 1986.

3. SDA's application in various disciplines is re- viewed in H. Theil, Statistical Decomposition Analy- sis (Amsterdam: North-Holland Publishing Com- pany, 1972). B. Lev, in Financial Statement Analysis (Englewood Cliffs, NJ: Prentice Hall, 1974), dis- cusses the additivity property of the decomposi- tion measure and describes various accounting and financial uses of the SDA.

Stock Index Futures and Cash Market Volatility

by Edwin D. Maberly, Associate Professor, College of Business Administration, Northern Arizona University, David S. Allen, Assistant Professor, College of Business Administration, Northern Arizona University, and Roy F. Gilbert, Associate Professor, Department of Econom- ics, Texas A&M University

Edwards recently investigated the allegation that the introduction of the S&P 500 futures contract on April 21, 1982 coincided with an increase in cash market volatility.1 The implication is that a cause and effect relationship exists between the introduction

of index futures in 1982 and a perceived increase in volatility. Edwards divided the period 6/1/73 to 12/31/86 into three subperiods based on a significant shift in the stochastic process of real interest rates in October 1979 and October 1982, when the Federal Reserve altered its behavior.2 He found no evidence of increased volatility over the period 10/1/82 to 12/31/86 (1982-86) compared with the subperiods 6/1/73 to 9/30/79 (first subperiod) and 10/1/79 to 9/30/82 (second subperiod).3 In fact, volatility, as measured by the variance of daily returns for the S&P 500 index, was shown to be significantly lower in 1982-86 than in either earlier subperiod. A gradual increase in vola- tility was noted beginning in 1986, with the increase becoming more pronounced in 1987. This increase in volatility was not associated with trading in the S&P futures contract.

This paper re-examines the controversy surround- 1. Footnotes appear at end of article.

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1989 O 75

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Table I Volatility of Bull and Bear Markets

Bull Market Bear Market

Period Change Period Change 01/01/63 to 02/09/66 40.57 02/10/66 to 10/07/66 -25.07 10/10/66 to 11/29/68 39.23 12/02/68 to 05/26/70 -44.72 05/27/70 to 04/28/71 41.34 04/29/71 to 11/23/71 -15.01 11/24/71 to 01/11/73 29.79 01/12/73 to 10/03/74 -65.78 10/04/74 to 09/21/76 54.70 09/22/76 to 03/06/78 -21.39 03/07/78 to 11/28/80 48.05 12/01/80 to 08/12/82 -31.62 08/13/82 to 10/10/83 52.21 10/11/83 to 07/24/84 -15.52 07/25/84 to 08/25/87 82.34 08/26/87 to 10/16/87* -17.50 10/20/87 to 12/30/88 21.12

Variance of Daily Returns

Period Bull Bear F P-Value

1/1/63 to 10/16/87 0.60408 0.72376 1.1981 <0.0001 (2150,4082)

1/1/63 to 12/30/88 0.71396 0.96488 1.3514 <0.0001 (2151,4386)

* This period should include 10/19/87 (the crash) based on our definition of a bear market. For the period 8/26/87 to 10/19/87, which includes the crash, the percentage change = -40.40 (percentage change = 100 * logarithm of the price relative).

ing the introduction of index futures and volatility. Specifically, we present a theoretical argument in support of increased volatility precipitated by the introduction of index futures. Based on a naive defi- nition of "bull" and "bear" markets, volatility is shown to be asymmetric; it is significantly greater for bear than for bull markets. Whether volatility has increased, decreased or remained relatively constant since the introduction of the S&P futures contract depends upon the time periods selected for compar- ison.

Theoretical Argument Ross recently showed that, in an arbitrage-free

economy, the volatility of prices is directly related to the rate of information flow.4 Any event that in- creases the rate of information flow simultaneously increases price volatility. In his simple model, price volatility equals information volatility. Within Ross' framework, the introduction of index futures will increase volatility if this event corresponds to an increase in the rate of information flow. An increase in volatility can be justified theoretically; one has only to accept the argument that the introduction of index futures increased the rate of information flow to the cash market.

For example, Stoll and Whaley have argued that the introduction of index futures increased the speed with which certain types of information (i.e., inves- tors' opinions) are reflected in individual stock prices "and thereby increase[d] short-run volatility."5 It is thus not the existence of increased volatility that must be justified, but the magnitude of the increase.

Asymmetry The observation that stock prices overreact to neg-

ative information but not to positive information suggests that volatility might be asymmetric-that is, different for bull than for bear markets.6

We calculated daily S&P 500 index returns for the period 1/1/63 to 10/16/87 (pre-crash) from the CRSP (Center for Research in Security Prices) tape. Returns were categorized into bull and bear markets based on the following naive definition. We defined the span of bull and bear markets by major market turning points. Each market turning point (with the exception of the period 8/25/87 to 10/16/87) was a local maximum or minimum in the region containing all trading days within 145 trading days of the turning point. Further- more, each bull or bear market spanned more than 145 trading days, and the percentage change between end points exceeded 15 per cent (see Table I).

We tested the hypothesis that no difference in volatility exists between bull and bear markets for the period 1/1/63 to 10/16/87. The empirical results (see Table I) indicate that volatility is significantly greater for bear versus bull markets (F = 1.1981, p-value < 0.0001). This observation becomes even more pro- nounced if we include return data for the period 10/19/87 to 12/31/88. Based on Ross' argument, either the rate of information flow increases during bear markets relative to bull markets, or arbitrage exists.

Volatility and Stock Index Futures Edwards reported a significant decrease in volatility

as measured by the variance of daily returns on the S&P index over the post-S&P futures period 10/1/82 to

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1989 O 76

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Table II Volatility of S&P 500 Index

Variance of Daily Returns F-Statistics

Date Total Bull Bear Fl F2 Pre-S&P Futures

01/01/63 to 04/20/82 0.6013 0.5159 0.7198 N/A N/A Observations 4842 3008 1834 06/01/73 to 04/20/82 0.8463 0.8393 0.8388 N/A N/A Observations 2245 1189 1056

Post-S&P Futures 04/21/82 to 10/16/87 0.8391 0.8504 0.7479 1.3955* 1.0086 Observations 1390 1074 316 04/21/82 to 10/19/87 1.2176 0.8504 2.3793 2.0250* 1.4387* Observations 1391 1074 317 04/21/82 to 12/30/88 1.3919 1.1464 2.3793 2.3148* 1.6447* Observations 1695 1378 317 01/01/87 to 12/31/87 4.5156 N/A N/A N/A N/A Observations 253 01/01/88 to 12/31/88 1.1847 N/A N/A N/A N/A Observations 253

* P-Value <0.0001. The F-statistic tests the hypothesis of equal volatility between the post-futures period and the pre-futures pe- riod. Fl corresponds to the pre-futures period 1/1/63 to 4/20/82. F2 corresponds to the pre-futures period 6/1/73 to 4/20/82.

12/31/86 compared with both the first and second subperiods.7

We tested for a difference in volatility between the post-S&P futures period 4/21/82 to 10/16/87 (pre- crash) and the pre-S&P futures period 1/1/63 to 4/20/82. The results (see Table II) indicate that volatil- ity is significantly greater for the post-S&P futures period (F = 1.3955, p-value < 0.0001). But a compar- ison of the post-S&P futures period 4/21/82 to 10/16/87 with the pre-S&P futures period 6/1/73 to 4/20/82 yielded conflicting results; volatility was not statisti- cally different between the two periods (F = 1.0086, p-value = 0.4965).8 We next compared the pre-S&P futures period 6/1/73 to 4/20/82 with the post-S&P futures period 4/21/82 to 12/31/88 and found volatility to be statistically greater for the post-S&P futures period (F = 1.6447, p-value < 0.0001).

These results are presented to emphasize the fact that, statistically, one can show that volatility has increased, decreased or remained relatively constant since the introduction of the S&P futures contract by judiciously selecting the pre and post-futures periods for comparison. If we consider only the pre-crash period, then the statistical evidence is inconclusive. If

we consider the post-crash period through 12/31/88, then the statistical evidence indicates that volatility has increased significantly since the introduction of the S&P futures contract.9

We calculated volatility for 1987 and 1988. Volatility increased significantly in both years. The level of volatility recorded for 1987 and 1988 was quite large compared with past norms, especially for 1987. Based on Ross' argument, this observation is consistent with the conjecture that a significant increase in the flow of information to the market occurred in both 1987 and 1988. To what extent the introduction of index futures affected information volatility is an area for further investigation.

Footnotes 1. F. Edwards, "Futures Trading and Cash Market

Volatility: Stock Index and Interest Rate Futures," The Journal of Futures Markets, April 1988, and Edwards, "Does Futures Trading Increase Stock Market Volatility?" Financial Analysts Journal, Jan- uary/February 1988.

2. Edwards, "Futures Trading and Cash Market Vol- atility," op. cit.

3. The second subperiod overlaps the introduction of the S&P futures contract by five months (April 21, 1982 to September 30, 1982).

4. S. Ross, "Information and Volatility: The No- Arbitrage Martingale Approach to Timing and Resolution Irrelevancy," The Journal of Finance, March 1989.

5. H. Stoll and R. Whaley, "Futures and Options on Stock Indexes: Economic Purpose, Arbitrage, and Market Structure," The Review of Futures Markets 2(1988), pp. 232-240.

6. See, for example, W. DeBondt and R. Thaler, "Does the Stock Market Overreact?" The Journal of Finance, July 1985, and K. Brown and W. Har- low, "Market Overreaction: Magnitude and In- tensity," Journal of Portfolio Management, Winter 1988.

7. Edwards, "Futures Trading and Cash Market Vol- atility," op. cit.

8. Edwards considered a similar period 6/1/73 to 9/30/82. We excluded the portion that overlaps trading in the S&P futures contract.

9. This observation does not necessarily imply that a cause and effect relationship exists between the introduction of stock index futures and an ob- served increase in volatility.

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1989 0 77

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