Impact of Derivatives on Indian Stock Market1

Ravi Agarwal2
ravi.agarwal@bimtech.ac.in
Shiva Kumar3
shiva.kumar10@bimtech.ac.in
Wasif Mukhtar3
wasif.mukhtar10@bimtech.ac.in
Hemanth Abar3
hemant.abar10@bimtech.ac.in

Keywords: Derivatives, Volatility, GARCH

JEL Classifications: C25, C22, G12, N25, G15

Presented in Indian Finance Summit 2009, organized by BIMTECH, Greater Noida, India.
Associate Professor of Finance, BIMTECH, Greater Noida, India.
3
Class of 2010, PGDM program, BIMTECH, Greater Noida, India.
2

Electronic copy available at: http://ssrn.com/abstract=1500327

Impact of Derivatives on Indian Stock Market

Introduction:

Derivatives, such as futures or options, are financial contracts which derive

their value from a spot price, which is called the underlying. Derivative products
like index futures, stock futures, index options and stock options have become
important instruments of price discovery, portfolio diversification and risk hedging
in stock markets all over the world in recent times. In the last decade, many
emerging and transition economies have started introducing derivative contracts.
Ever since index futures were introduced by the National Stock Exchange (NSE) in
June 2000, there has been a lot of controversy regarding their usage. Derivatives
are known to be a double edged sword, you can use it to kill enemies, kill yourself
or for self-defense.
Introduction of derivative products, however, has not always been perceived
in a positive light all over the world. It is, in fact, perceived as a market for
speculators and concerns that it may have adverse impact on the volatility of the
spot market. Government had earlier banned futures trading in commodities on the
belief that they were over speculated and caused an inflationary situation. Now
trading has been resumed on four banned commodities, after the inflation rate has
moderated. There is also a hope that government may soon lift the trading ban on
food grains. This offers great relief for importers and exporters to hedge their
positions. Earlier, an expert committee headed by Abhijit Sen was constituted to
study the impact of futures trading on agricultural commodity prices. Wheat, urad,
tur and rice were among the products that were considered in the report.
This paper tries to study whether the Indian stock markets show some
significant change in the volatility after the introduction of derivatives trading. This
paper also tries to examine whether decline or rise in volatility can be attributed to
introduction of derivatives alone or due to some other macroeconomic reasons.

Electronic copy available at: http://ssrn.com/abstract=1500327

Literature Review

There is a common belief that stock index futures are more volatile than
underlying spot market because of their operational and institutional properties.
The close relationship between the two markets makes the transfer of volatility
possible from futures market to the underlying spot market. It is therefore, not
surprising that the inception of futures contract relating to stock market has
attracted the attention of researchers all over the world, and also led some
observers to attribute stock market volatility to futures trading. Various studies
have been conducted to assess the impact of derivatives trading on the underlying
market mostly related to US and other developed countries markets. Very few
studies attempted to know the impact of introduction of derivatives trading in
emerging market economies like India.
Both theoretical and empirical studies were carried out to assess the impact
of listing of futures and options on the cash market. Two main bodies of theory
about the impact of derivatives trading on the spot market are prevailing in the
literature and both are contradicting each other. One school of thought argues that
the introduction of futures trading increases the spot market volatility and thereby,
destabilizes the market. They are the proponents of Destabilizing forces
hypothesis. (Lockwood and Linn, 1990)) They explain that derivatives market
provides an additional channel by which information can be transmitted to the cash
markets. Frequent arrival and rapid processing of information might lead to
increased volatility in the underlying spot market. They also attribute increased
volatility to highly speculative and levered participants.
Others argue that the introduction of futures actually reduces the spot market
volatility and thereby, stabilises the market. They are the proponents of Market
completion hypothesis. (Satya Swaroop Debasish, 2007). Kumar et al (1995) argued
that derivatives trading helps in price discovery, improve the overall market depth,
enhance

market

efficiency,

augment

market

liquidity,

reduce

asymmetric

information and thereby reduce volatility of the cash market. The impact that the
derivatives market has on the underlying spot market remains an issue debated
again and again with arguments both in favour and against them.

This study seeks to examine the volatility of the spot market due to the
derivatives market. Whether the volatility of the spot market has increased,
decreased or remained the same. If increased then, what extent it is due to futures
market. We use Autoregressive framework to model returns volatility. To measure
volatility in the markets, the VIX (Volatility Index) computed by the National Stock
Exchange is used. To eliminate the effect of factors other than stock index futures
(i.e., the macroeconomic factors) determining the changes in volatility in the post
derivative period, the model is used for estimation after adjusting the stock return
equation for market factors.
The studies is in the Indian context have evaluated the trends in NSE and not
on the Stock Exchange, Mumbai (BSE) for the reason that the turnover in NSE
captures an overwhelmingly large part of the derivatives market.
We use Nifty Junior as surrogate indices to capture and study the market
wide factors contributing to the changes in spot market volatility. This gives a
better idea as to whether the introduction of index futures in itself caused a decline
in the volatility of spot market or the overall market wide volatility has decreased,
and thus, causing a decrease in volatility of indices on which derivative products
have been introduced. The volumes on NIFTY also has a large impact on the
volatility, thus in the model to measure volatility volumes are also considered as a
factor. We seek to compare this volatility with the volatility prevailing in the market
before the index futures (i.e. Nifty futures) and check if it is statistically significant.

Data and Methodology:

We used daily data for our study obtained from different sources. Data on
daily movement of NSEs indices such as S&P CNX Nifty, Nifty Futures VIX (Volatility
Index) and NIFTY Volumes were collected from www.nseindia.com. We propose to
construct our model on the recent data of these indices.
To also addresses the issue of whether introduction of derivatives (Futures
and Options) has been the only factor responsible for the change in volatility we
include returns from a surrogate index Nifty Junior into mean equation to account
for the additional factors affecting the volatility of the market. It is worthy to note
that Nifty Junior is not traded in futures market.
We are using two models arrive at a conclusion on our studies. The first
model examines if there is any significant variances in thee movements of NIFTY
and NIFTY Junior. In the second model i.e. the auto-regressive model, the volatility
is given as equation of NIFTY Futures, NIFTY Junior and Volumes.

We will be

explaining the data and methodology of each model in detail when explaining that
model.

MODEL 1- Using Variances in NIFTY and NIFTY Junior

Standard Deviation

Value

NIFTY

0.016714

NIFTY JUNIOR

0.019317

Standard Deviation measures the volatility of the data and would be the most
appropriate to use for comparison. When we compare the Standard Deviation, it is
higher in case of NIFTY JUNIOR, we can infer that NIFTY is less volatile than NIFTY
JUNIOR. We can test it using F statistic, test for variances. We get the following
result from MS Excel.

Null Hypothesis:
There is no significant difference between the variances in price changes in NIFTY
and Nifty Futures.

Alternate Hypothesis:
There is significant difference between the variances in price changes in NIFTY and
Nifty Futures.
F-Test Two-Sample for Variances
NIFTY
%age
Chg
Mean
0.000427224
Variance
0.00027639
Observations
2125
Df
2124
F
0.744337104
P(F<=f) one-tail
5.57798E-12
F Critical one-tail 0.931092597

%AGE NIFTY
JR
0.000374095
0.000371323
2125
2124

Statistical Result:
We tend to accept the Null Hypothesis at 95% Level of Significance. Hence
there is no significant difference in the variance of NIFTY.

Conclusion:
Since NIFTY Junior does not contain Futures. We are comparing it with NIFTY,
which has futures and hence testing for any significant difference. With the F test
for variance, we conclude that there is no significant difference in NIFTY and Nifty
futures. We can conclude that NIFTY Futures doesnt contribute towards volatility of
NIFTY.

MODEL 2 Using Regression Analysis

Data and Methodology
We use a regression model to capture the volatility of NIFTY. The dependent
variable, we take as the Volatility Index (VIX). The volatility in the market is
generally due to the Macro-Economic Variables, Futures (We are interested in
checking this), and stock volumes. Thus when we regress this model and get the
result using SPSS.
Yt = b0 + b1Xt-1 + b2X2 + b3X3 + b4X4 + e
where Y = Volatility Index
i = regression coefficients
Xt-1= Volatility Index
X2 = Nifty 1 Month Futures
X3 = Nifty Junior
X4 = Nifty Volumes
e = random error term

Volatility Index VIX

Volatility Index is a measure of markets expectation of volatility over the
near term. Volatility is often described as the rate and magnitude of changes in
prices and in finance often referred to as risk. Volatility Index is a measure, of the
amount by which an underlying Index is expected to fluctuate, in the near term,
(calculated as annualised volatility, denoted in percentage e.g. 20%) based on the
order book of the underlying index options. Volatility Index is a good indicator of
the investors perception on how volatile markets are expected to be in the near
term. Usually, during periods of market volatility, market moves steeply up or down
and the volatility index tends to rise. As volatility subsides, option prices tend to
decline, which in turn causes volatility index to decline.

Computation methodology:
The generalized formula used in the India VIX calculation is:

Durbin-Watson Statistic
The DurbinWatson statistic is a test statistic used to detect the presence of
autocorrelation in the residuals from a regression analysis. It is named after James
Durbin and Geoffrey Watson. Its value always lies between 0 and 4.
A value of 2 indicates there appears to be no autocorrelation. If the DurbinWatson
statistic is substantially less than 2, there is evidence of positive serial correlation.
As a rough rule of thumb, if DurbinWatson is less than 1.0, there may be cause for
alarm. Small values of d indicate successive error terms are, on average, close in
value to one another, or positively correlated. Large values of d indicate successive
error terms are, on average, much different in value to one another, or negatively
correlated

Determine based on Eigenvalues.

An eigenvalue represents the amount of variance associated with the factor.
Generally only factors with an Eigenvalue of >1.0 is included.

Model Summary
Std. Error Change Statistics
Mod

Adjusted of

el

.694a .481

the R

Square R Square Estimate

.479

8.03216

Square F

Sig.

Change

Change df1

df2

Change

.481

247.65 1

267

.000

266

.000

F DurbinWatson

7
2

.828b .685

.683

6.26741

.204

172.53 1

.517

1
a. Predictors: (Constant), FUT1
b. Predictors: (Constant), FUT1, NIFTYJR
c. Dependent Variable: VIX

A Durbin-Watson Statistic below 1 is a cause of alarm. There is auto correlation

between the variables in VIX. We go for Auto-Regressive model.

Model Summary
Std. Error Change Statistics
Mod

el

.930a .866

Adjusted

Square R Square
.865

of

the R

Square F

Sig.

Estimate

Change

Change df1

df2

Change

4.07893

.866

1712.2 1

266

.000

F DurbinWatson

27
2

.932b .869

.868

4.03100

.004

7.364

265

.007

.934c .873

.872

3.97537

.004

8.468

264

.004

.936d .875

.873

3.95245

.002

4.071

263

.045

a. Predictors: (Constant), AUTOVIX

b. Predictors: (Constant), AUTOVIX, FUT1
c. Predictors: (Constant), AUTOVIX, FUT1, NIFTYJR

2.228

d. Predictors: (Constant), AUTOVIX, FUT1, NIFTYJR, NIFTYVOL

e. Dependent Variable: VIX

ANOVA
Sum
Model
1

of

Squares

df

Mean Square F

Regression 28487.464

28487.464

Residual

4425.618

266

16.638

Total

32913.083

267

Regression 28607.116

14303.558

Residual

4305.967

265

16.249

Total

32913.083

267

Regression 28740.933

9580.311

Residual

4172.149

264

15.804

Total

32913.083

267

Regression 28804.523

7201.131

Residual

4108.560

263

15.622

Total

32913.083

267

1712.227 .000a

880.277

.000b

606.211

.000c

460.964

.000d

a. Predictors: (Constant), AUTOVIX

b. Predictors: (Constant), AUTOVIX, FUT1
c. Predictors: (Constant), AUTOVIX, FUT1, NIFTYJR
d. Predictors: (Constant), AUTOVIX, FUT1, NIFTYJR, NIFTYVOL
e. Dependent Variable: VIX

Sig.

Coefficients
Standardi
zed
Unstandardized

Coefficie

Coefficients

nts

Collinearity

Std.
Model
1

(Consta 2.707

Error

Beta

.879

Sig.

Correlations

Statistics

Zero-

Tolera

order

Partial Part

nce

VIF

.930

.930

.930

1.000

1.000

.930

.866

.627

.516

1.937

-.690

-.164 -.060 .516

1.937

.930

.774

.298

3.353

-.690

-.203 -.074 .018

54.70

3.079 .002

nt)
AUTOVI .926

.022

.930

X
2

41.37 .000
9

(Consta 9.538

2.663

3.582 .000

nt)
AUTOVI .868

.031

.872

X
FUT1

28.19 .000
7

.000

.000

-.084

.007

2.714
3

(Consta 22.118

5.058

4.372 .000

nt)
AUTOVI .793

.040

.796

X
FUT1

19.84 .000

.435

2
-.006

.002

-.547

.001

3.376
NIFTYJR .002

.001

.419

2.910 .004

-.585

.176

.064

.023

43.16
3

(Consta 26.452

5.469

4.837 .000

nt)
AUTOVI .794

.040

.797

X
FUT1

19.98 .000

.930

.776

.435

.298

3.353

-.690

-.214 -.077 .018

55.05

3
-.007

.002

-.573

.000

3.545
NIFTYJR .002

.001

.440

3.065 .002

-.585

.186

.067

.023

43.39
1

NIFTYV OL

6.777E7

.000

-.045

2.018

.045

.107

-.123 -.044 .969

1.032

Coefficients
Standardi
zed
Unstandardized

Coefficie

Coefficients

nts

Collinearity

Std.
Model
1

(Consta 2.707

Error

Beta

.879

Sig.

Correlations

Statistics

Zero-

Tolera

order

Partial Part

nce

VIF

.930

.930

.930

1.000

1.000

.930

.866

.627

.516

1.937

-.690

-.164 -.060 .516

1.937

.930

.774

.298

3.353

-.690

-.203 -.074 .018

54.70

3.079 .002

nt)
AUTOVI .926

.022

.930

X
2

41.37 .000
9

(Consta 9.538

2.663

3.582 .000

nt)
AUTOVI .868

.031

.872

X
FUT1

28.19 .000
7

.000

.000

-.084

.007

2.714
3

(Consta 22.118

5.058

4.372 .000

nt)
AUTOVI .793

.040

.796

X
FUT1

19.84 .000

.435

2
-.006

.002

-.547

.001

3.376
NIFTYJR .002

.001

.419

2.910 .004

-.585

.176

.064

.023

43.16
3

(Consta 26.452

5.469

4.837 .000

nt)
AUTOVI .794

.040

.797

X
FUT1

19.98 .000

.930

.776

.435

.298

3.353

-.690

-.214 -.077 .018

55.05

3
-.007

.002

-.573

.000

3.545
NIFTYJR .002

.001

.440

3.065 .002

-.585

.186

.067

.023

43.39
1

NIFTYV OL

.000

6.777E7

a. Dependent Variable: VIX

-.045

2.018

.045

.107

-.123 -.044 .969

1.032

Excluded Variables
Collinearity Statistics
Partial
Model
1

Beta In

Sig.

Correlation

Tolerance VIF

Tolerance

-.058a

-2.114

.035

-.129

.654

1.528

.654

NIFTYVOL -.037a

-1.624

.105

-.099

.976

1.024

.976

FUT1

-.084a

-2.714

.007

-.164

.516

1.937

.516

NIFTYJR

.419b

2.910

.004

.176

.023

43.163

.018

NIFTYVOL -.040b

-1.772

.078

-.108

.974

1.026

.513

NIFTYVOL -.045c

-2.018

.045

-.123

.969

1.032

.018

NIFTYJR

Minimum

a. Predictors in the Model: (Constant), AUTOVIX

b. Predictors in the Model: (Constant), AUTOVIX, FUT1
c. Predictors in the Model: (Constant), AUTOVIX, FUT1, NIFTYJR
d. Dependent Variable: VIX

Collinearity Diagnostics
Dimen

Condition

Variance Proportions

Model sion

Eigenvalue Index

(Constant) AUTOVIX FUT1

1.959

1.000

.02

.02

.041

6.912

.98

.98

2.894

1.000

.00

.00

.00

.100

5.380

.00

.24

.08

.006

22.885

1.00

.76

.92

3.836

1.000

.00

.00

.00

.00

.152

5.027

.00

.09

.00

.00

.012

18.054

.11

.32

.00

.04

.000

94.962

.89

.58

1.00

.96

4.814

1.000

.00

.00

.00

.00

.00

.156

5.560

.00

.08

.00

.00

.00

.022

14.629

.00

.28

.00

.01

.40

.007

26.339

.16

.07

.01

.03

.58

.000

107.455

.84

.57

.99

.95

.02

NIFTYJR

NIFTYVOL

Collinearity Diagnostics
Dimen

Condition

Variance Proportions

Model sion

Eigenvalue Index

(Constant) AUTOVIX FUT1

1.959

1.000

.02

.02

.041

6.912

.98

.98

2.894

1.000

.00

.00

.00

.100

5.380

.00

.24

.08

.006

22.885

1.00

.76

.92

3.836

1.000

.00

.00

.00

.00

.152

5.027

.00

.09

.00

.00

.012

18.054

.11

.32

.00

.04

.000

94.962

.89

.58

1.00

.96

4.814

1.000

.00

.00

.00

.00

.00

.156

5.560

.00

.08

.00

.00

.00

.022

14.629

.00

.28

.00

.01

.40

.007

26.339

.16

.07

.01

.03

.58

.000

107.455

.84

.57

.99

.95

.02

NIFTYJR

a. Dependent Variable: VIX

Residuals Statistics
Minimum

Maximum Mean

Predicted Value

24.7768

79.5547

Residual

-20.76211 21.75052 .00000

Std.

Predicted -1.234

Std. Deviation N

37.5897 10.38663

268

3.92274

268

4.040

.000

1.000

268

5.503

.000

.992

268

Value
Std. Residual

-5.253

a. Dependent Variable: VIX

NIFTYVOL

Statistical Result:
A R Square of 0.873 indicates the degree to which volatility is explained by
the independent variables, with the incremental part of it being highest for auto
correlated variable, the volatility index. Durbin-Watson Statistic of 2.229 indicates a
low auto correlation, which is desirable.
The critical F value of 460.964 indicates the strength of the strength of our
regression model. The p value is also extremely low.
We get a regression model from the data:
Yt = 26.452 + 0.794Xt-1 + .007X2 + .002X3 + 0X4 + e
where Y = Volatility Index
i = regression coefficients
Xt-1= Volatility Index
X2 = Nifty 1 Month Futures
X3 = Nifty Junior
X4 = Nifty Volumes
e = random error term
The p value is very low for b2, hence indicating the significant contribution of Nifty
futures towards predicting Volatility,
The predicted volatility value for VIX will lie in the range 24.7768 to 79.5547
with a mean of 37.5897 with a standard deviation of 10.39.

Conclusion:
With the regression model we can see that the beta of futures i.e. b2 is 0.007. This beta value is significant. This implies that futures contribute towards
stabilizing the market.

Final conclusion:
We have found conclusions from both Model 1 and 2 against the theory that
Futures contribute towards the volatility in stock market. While Model 1 suggests
that Futures do not contribute to the variances in stock market, the second model
suggests that futures contribute towards stabilizing the market. Hence derivatives
contribute towards stabilizing stock market.

Reference:

Impact of futures Trading activity on stock price volatility Satya Swaroop Debasish
ICFAI Journal of Derivatives Market.
Impact of futures introduction on underlying index volatility Evidence from indiaKotha Kiran Kumar & Chiranjit Mukhopadhyay
Estimation of GARCH models based on open, close, high, and low prices-Peter M.
Lildholdt
Basic Econometrics- Gujatati
Impact Of Futures And Options On The Underlying Market Volatility: An Empirical
Study On S & P Cnx Nifty Index - Mr. Sibani Prasad Sarangi1 & Dr. K. Uma Shankar
Patnaik 2