Analysis

Future Trading and Stock Market Volatility: A

study of Bank Nifty

1
Ruchika Gahlot

Saroj K. Datta2

Abstract
Futures are considered as important tool for risk hedging but it may
add to the volatility of the market. The objective of this paper is to
investigate the impact of future trading on volatility of stock prices of
banking sector. The sample data consist of closing prices of Bank Nifty
as well as closing prices of individual banks from April 1, 2003 to
March 31, 2008. The study uses least square method and EGARCH
model to capture the leverage effect and volatility clustering
phenomenon of data. The evidences suggest that introduction of future
doesn’t affect volatility of Bank Nifty as well as individual banks except
Axis, IDBI and ICICI banks. The result also shows the presence of
leverage effect i.e. good and bad news doesn’t have equal effect on
volatility. This paper will contribute to evaluate the impact of future
trading on stock market volatility of banking sector. Since this study is
carried out on banking sector, it will not be easy to generalize the
results and further research is required to evaluate how introduction of
future trading affect other sectors.
Keywords: EGARCH, Volatility, Bank nifty, Derivatives

1
Research scholar, Faculty of Management Studies,
Mody Institute of Technology and Science, Rajasthan, India
E-mail: [email protected], [email protected]
2
Professor and Dean, Faculty of Management Studies,
Mody Institute of Technology and Science Rajasthan, India
E-mail: [email protected]

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Introduction

A derivative is financial instrument which derives its value from

the underlying asset. The price of derivatives is driven by the spot
price of underlying asset. The main objectives for introducing
derivatives in India were to fully integrate the Indian financial
markets with globally developed countries, to improve the
information efficiency and to provide tools for risk management.
In India, derivatives trading started in June 2000 with
introduction of Index future followed by index options in June
2001, and options and futures on individual securities in July
2001 and November 2001, respectively. Since inception, NSE
established itself as the sole market leader in this segment in the
country and during 2008-09, it accounted for 99 % of the market
share (NSE, 2009). The total turnover on the F&O Segment was
Rs. 11,010,482 crore (US $ 2,161,037 million) during 2008-
09.The average daily turnover during 2008-09 was Rs.45, 311
crore (US $ 8,893 million).
Most of the Indian studies are conducted on S&P CNX Nifty.
Only few studies are conducted on sector based indices as SEBI
is introducing more future and option contracts on these indices.
In this paper, we will study the impact of future trading on Bank
Nifty. Bank Nifty Index is an index comprised of the most liquid

324
and large capitalized Indian Banking stocks. It provides investors
and market intermediaries with a benchmark that captures the
capital market performance of Indian Banks. The index will have
12 stocks from the banking sector which trade on the National
S t o c k E xchange.
The total traded value for the last six months of Bank Nifty Index
stocks is approximately 96.46% of the traded value of the
banking sector. Bank Nifty Index stocks represent about 87.24%
of the total market capitalization of the banking sector as on
March 31, 2009.
The total traded value for the last six months of all the Bank Nifty
Index constituents is approximately 15.26% of the traded value of
all stocks on the NSE. Bank Nifty Index constituents represent
about 7.74% of the total market capitalization as on March 31,
2009.
This research intends to achieve following objectives:
1. To study the impact of future on volatility of stock prices
of Bank Nifty and individual banks.
2. To measure the leverage effect with the help of
EGARCH model.
3. To analyze whether volatility of public sector bank differ
from private sector bank.

325
Literature Review

Majority of the studies reported reduction in the cash market

volatility after introduction of derivatives trading. Freris (1990)
using Hang Seng index in Hong Kong, Baldauf and Santoni
(1991) using the S&P 500 index in the USA, Chatrath et al.
(1995) for S&P 100 index in the USA, Pericli and Koutmos
(1997) using S&P 500 index in USA, Antoniou et al. (1998)
using the S&P 500 index in the USA, Dennis and Sim (1999) for
Australia, and Cohen (1999) for the USA, Japan and UK support
this proposition. Pilar and Rafael (2002) for Spain and Bologna
and Cavallo (2002) for Italy also found decrease in stock market
volatility after the introduction of stock index futures.
The alternative proposition is that derivative trading increase the
volatility in stock market. Lee and Ohk(1992) for Japan , UK and
USA , Kamara et al. (1992) for the S&P 500 in USA , Antoniou
and Holmes (1995) for the FTSE 100 in UK, Chang et al. (1999)
for the Nikkie index in Japan, found support to this proposition.
Butterworth (2000) for the FTSE Mid 250 index in the UK,
Chiang and Wang (2002) for TAIEX futures in Taiwan , Ryoo
and Smith (2004) for the Korean stock market and Pok and
Poshakwala (2004) for the Malaysian stock market found an
increase in the volatility of the cash market after introduction of
stock index future. Yu (2001) found that the volatility of stock

326
returns increased in the USA, France, Japan and Australia, but
didn’t change in the UK and Hong Kong on introduction of
futures.
In the first study on the impact of listing options on the Chicago
Board of Exchange, Nathan Associates (1974) reported that the
introduction of options had helped stabilize the cash market. This
result has been supported by Skinner (1989). Freund et al. (1994)
and Bollen (1998) have found that the direction of volatility
effect is not consistent over time.
There are conclusions of ‘no effects’ also in the literature of
derivative listing. Kabir (1999) observes significant decline in
stock price with the introduction of option trading, but no
significant change in the volatility of underlying stocks. Dennis
and Sim (1999) document little or no significant impact of future
trading on spot market volatility for Australian market and for the
three nations of Maxico, Brazil, and Hungary, respectively.
Rahman(2001) for DJIA index, Antoniou et al. (1998) for S&P
500, Mallikarjunappa and Afsal (2008) for Bank Nifty reported
no change in volatility after the introduction of derivative trading.
Drimbetas et al. (2007) studied the effect of introduction of future
& options on the volatility of underlying index i.e. FTSE/ASE 20
Index by using EGARCH model. He reported reduction in the
conditional volatility of index and consequently increases its
efficiency.

327
Kim et al. (2004) explored the relationship between the trading
activities of the Korea Stock Price Index 200 derivatives
contracts and their underlying stock market volatility. He found
positive contemporaneous relationship between the stock market
volatility and the derivative volume while the relationship is
negative between the volatility and open interest.
Pilar and Rafael (2002) investigated the effect of the introduction
of derivatives on the volatility and on the trading volume of the
underlying Ibex 35 index of Spanish market using GJR model. It
is found that trading volume of Ibex 35 increased and the
conditional volatility declined after derivative markets are
introduced.
Rahman (2001) examined the impact of trading in DJIA index
futures and futures options on the conditional volatility of
component stocks. He estimated the conditional volatility of
intraday returns for each stock before and after the introduction
of derivatives using GARCH model. The result indicates that
there is no structural change in the conditional volatility of
component stocks after introduction of derivatives.
Antoniou et al. (1998) examined the impact of future trading on
the volatility of S&P 500 index with asymmetric GARCH model
and found that introduction of future doesn’t have a detrimental
effect on the underlying spot market.

328
Pericli and Koutmos (1997) estimated the volatility of Standard
& Poor’s (S&P) 500 index after introduction of future trading by
using EGARCH model and found decline in the volatility of S&P
index
Antoniou and Holmes (1995) studied the volatility of FTSE 100
index using GARCH model and found significant increase in
cash market volatility after introduction of FTSE 100 index in
1984.
Lee & Ohk (1992) examined the effects of introducing index
futures trading on volatility of stock return in Australia, Hong
Kong, Japan, United Kingdom, and United States of America.
They found that stock volatility increased significantly shortly
after the listing of the stock index future, with the exception of
the stock markets in Australia and Hong Kong.
Hodgson and Nicholas (1991) studied the impact of All Ordinary
Share Price Index (AOI) futures on the Associated Australian
Stock Exchanges over the All Ordinary Share Index by
estimating standard deviation of daily and weekly returns to
measure the change in volatilities of the underlying Index and
found that the introduction of futures and options trading has not
affected the long term volatility.
Chan et al. (1991) estimated intraday volatility of S&P 500 and
major market index future by using bivariate GARCH model and
found strong intermarket dependence in the volatility of cash

329
market and future market. It was also shown that the intraday
volatility pattern originates either in stock or future market
demonstrated predictability in the other market.
Laatch (1991) measured the effect oh introduction of future by
comparing the volatility of individual stocks within the Major
Market Index (MMI) to control the sample of stocks that were not
in the index and concluded that there was no significant effect on
volatility.
Harris (1989) studied the impact of index future on S&P 500 and
a non- S&P 500 group of stocks by comparing daily return
volatilities during the pre-futures and post future period. He
observed increased volatility after introduction of index futures.
Mallikarjunappa and Afsal (2008) studied impact of future
trading on spot market volatility of CNX Bank Nifty, a sector
based index by using GARCH model and Chow test for
parameter stability. The results showed that derivatives doesn’t
have any stabilizing (or destabilizing) effect by decreasing (or
increasing) the volatility.
Vipul (2006) used S&P CNX Nifty Index and individual stocks
(both derivative and non derivative) to study the impact of
derivative trading on the stock market volatility. He applied
extreme value measure of volatility and GARCH model and
found strong evidence of reduction in Extreme Value and

330
GARCH volatility after introduction of derivatives for all the
underlying (except Nifty).
Nagaraj and Kiran (2004) studied the impact of introduction of the
NSE Nifty index futures on Nifty Index volatility using ARMA-
GARCH model. They also examined the effect of September 11
terrorist attacks on the Nifty spot-futures relation and found relation
between futures trading activity and spot volatility after September 11
attacks.
Hetamsaria and Deb (2004) explored the impact of index futures on
the Indian stock market volatility using GARCH model and have
shown that the introduction of futures results in a reduction in the
spot market volatility. It also showed that domestic market factors
represented by the NSE 500 had a significant effect, in determining
the volatility of the Nifty index but the other international factors are
found to have significant effect.
Nath (2003) used the IGARCH model to study the behavior of stock
market volatility after the introduction of futures and concluded that
the volatility of Nifty index had fallen in the post future period.
Thenmozhi (2002) used the variance ratio test and Ordinary Least
Square Multiple Regression Technique to study the impact of the
introduction of Nifty index futures on underlying Nifty index
volatility in the Indian markets and concluded that futures trading
have reduced the volatility in the spot market.

331
Shenbagaraman (2002) examined the impact of introduction of the
NSE Nifty index futures on nifty index by using GARCH and
concluded that future has not led to any change in the volatility of the
underlying stock index but the structure of volatility seems to have
changed in post future period.
Research Gap:
This study is different from the existing literature on three
grounds. First, only one study has been conducted on Bank Nifty
which hasn’t considered the component stocks. Secondly, it uses
EGARCH model to measures leverage effect which states that
bad news and good news doesn’t have equal effect on the
volatility. Thirdly, it tries to compare volatility of public sector
banks with private sector banks.

Research Methodology

Data Collection

This paper studies the impact of future trading on the volatility of

banking sector. To represent the banking sector, Bank Nifty has
been selected along with its component scrips. Bank Nifty has 12
component banks of which Axis Bank, HDFC Bank, ICICI Bank,

332
Kotak Mahindra Bank and PNB are private and Bank of Baroda,
Bank of India, Canara Bank, IDBI Bank, Oriental Bank of
Commerce, SBIN and Union Bank of India are public banks. The
data is collected for 8 years i.e. 01-04-2003 to 31-03-2008. The
data is collected from the website of NSE. This paper uses the
daily closing prices of Bank Nifty and Nifty Junior Index to study
the impact of future trading on volatility of index.
Methodology
We have used Augmented Dickey- Fuller test and Phillips-Perron
test to check the of stationarity of series. The hypothesis of ADF
and PP test is:
H0 = The series has unit root
H1 = The series has no unit root.
ARCH LM test is used to test the ARCH effect. The null
hypothesis is:
H0 = There is no ARCH effect.
H1 = There is ARCH effect..
In order to analyze the impact of future trading on volatility of
Bank Nifty and component scrips, the use of conditional
volatility seems to be suitable. We chosen EGARCH model
proposed by Nelson (1991) instead of GARCH model to capture
asymmetric feature of data. The EGARCH model do not hold the
assumption of symmetrical effect on Volatility, allowing for
different handling of good and bad news and don’t have

333
restriction of positive sign on ARCH and GARCH coefficients.
The specification that has been used is:

Rt = α 0 + α 1 Rt-1 + α2 Dummy + ht

Dummy variable is included in the mean equation to measure the

impact of future which is 0 before introduction of future and 1
after their introduction. Positive coefficient of dummy implies
positive effect on the volatility and negative coefficient implies
negative effect after introduction of future.

w represent the constant, α measures the response of volatility to

yesterday’s news, λ shows leverage effect which can be known
from testing the hypothesis that λ=0. The impact is asymmetric if
λ 0 . β measures the persistence effect of volatility.
Least square method is used to measure the volatility of Kotak
Mahindra Bank as it can’t reject the null hypothesis of no ARCH
effect.

Empirical Results

334
The results were obtained on the basis of Rt which is rate of
return r in period t, computed as logarithmic first difference of
daily closing prices. The stationarity of data is checked by using
Augmented Dickey-Fuller test and Phillips-Perron test and results
are shown in Table1.
Both test reject null hypothesis of unit root and implies that all
the series are stationary and significant at 1% as computed value
is less than test critical value.
Table 1: Unit Root Test

Bank ADF Test PP Test

t statistic Adj. t-Stat
Bank Nifty -17.6694 -270.748 -

Axis Bank -17.89639 -382.9402 -

Bank of Baroda -18.56686 -342.7320 -
Bank of India -22.55775 -624.0592 -
Canara Bank -19.59519 -412.3016 -
HDFC Bank -16.64307 -558.8117 -
ICICI Bank -16.32700 -580.4848 -
IDBI Bank -17.67239 -1087.854 -

Kotak Mahindra Bank -21.23101 -425.4563 -

OBC -18.86424 -274.5517 -
PNB -19.41910 -697.2389 -

SBIN -17.28760 -887.4821 -

Union Bank -19.27458 -444.2270 -

Test critical values -2.566822 -1.941078 -1.616528
(ADF) (1%) (5%) (10%)

335
Test critical values (PP) -2.568028 -1.941243 -1.616417
(1%) (5%) (10%)

Table 2 shows descriptive statistic of returns of individual stock

and Bank Nifty. The average return and standard deviation of
Bank Nifty and all individual banks is positive. The average
return of private banks i.e. 0.0014634 is higher than average
return of public banks i.e. 0.001144.
The negative skewness of Bank Nifty as well as Bank of Baroda,
Canara Bank, Kotak Mahindra Bank, Oriental Bank of
Commerce, PNB, Union Bank of India and SBIN exhibits that
the returns distributions of the market have higher probability of
providing negative returns. The skewness of return is positive for
Axis Bank, Bank of India, HDFC Bank, ICICI Bank and IDBI
Bank. The high values of kurtosis as compared to 3, exhibits that
returns of Bank Nifty as well as individual banks have a heavier
tail than the standard normal distribution. The Jarque-Bera test
the normality of return which is significant at 5% level as p value
is less than 0.05.
Table 2: Descriptive Statistic

Bank Mean Standard Skewness Kurtosis Jarque-

Deviation Bera
Bank 0.001314 0.020865 -0.65556 8.215907 1514.933
Nifty
(0.000000)

336
Axis 0.002373 0.031600 0.344268 8.780856 1776.526
Bank (0.000000)
Bank of 0.000932 0.034576 - 8.192347 1447.829
Baroda 0.280252 (0.000000)
Bank of 0.001481 0.034423 0.120403 6.088262 502.5565
India (0.000000)
Canara 0.000889 0.032496 - 6.410684 619.4640
Bank 0.096024 (0.000000)
HDFC 0.001381 0.022765 0.288068 20.06793 15287.13
Bank (0.000000)
ICICI 0.001207 0.174445 0.055060 11.61398 4468.231
Bank (0.000000)
IDBI 0.001336 0.196217 0.188350 581.8415 17562601
Bank
(0.000000)
Kotak 0.001094 0.043675 - 162.4980 1348844
Mahindra 8.859469
Bank (0.000000)

OBC 0.000777 0.032373 - 10.67635 3156.576

0.425877
(0.000000)

PNB 0.001262 0.050713 - 10.11831 2774.462

0.297602 (0.000000)
SBIN 0.001251 0.076135 - 5.862969 483.9505
0.085436 (0.000000)
Union 0.001342 0.033485 - 7.106989 898.9015
Bank of 0.007445
India (0.000000)

Figures in ( ) represent p value.

EGARCH

337
The presence of ARCH effect is checked by ARCH LM test at
lag1. The results of ARCH LM reject the null hypothesis of no
ARCH effect (p value<0.05) except in case of Kotak Mahindra
Bank as shown in table 4. It implies that volatility is not
following the ARCH specification. It is not time-varying but
constant. So, Standard Deviation (or variance) of the error in
traditional regression model (OLS) is the better measurement of
the volatility for Kotak Mahindra Bank.
Table 4: ARCH Test

Bank F-statistic Obs*R-squared

Bank Nifty 363.5296 282.2278

(0.000000) (0.000000)
Axis Bank 82.82583 77.81810
(0.000000) (0.000000)
Bank of Baroda 480.5492 349.1810
(0.000000) (0.000000)
Bank of India 87.52115 81.93756
(0.000000) (0.000000)
Canara Bank 59.79977 57.20057
(0.000000) (0.000000)
HDFC Bank 327.7535 260.2545
(0.000000) (0.000000)
ICICI Bank 584.5273 416.4214
(0.000000) (0.000000)
IDBI Bank 119.1315 108.9693
(0.000000) (0.000000)
Kotak Mahindra Bank 0.025000 0.025040
(0.874392) (0.874268)
OBC 369.3436 286.3788

338
 (0.000000) (0.000000)
PNB 200.5468 174.0289
(0.000000) (0.000000)
SBIN 129.0322 118.3680
(0.000000) (0.000000)
Union Bank of India 147.6417 132.5270
(0.000000) (0.000000)
Figures in ( ) represent p value
Table 5 shows the results of EGARCH. for Bank Nifty. w is
intercept which is negative and significant for Bank Nifty. α
shows response of volatility to market news which is positive and
significant. λ shows leverage effect which is negative and
significant. β represent the persistence of volatility which is very
high i.e. 0.888235. Dummy’s coefficient is negative and
insignificant implying that market volatility is not influenced by
the introduction of futures trading.

Table 5: EGARCH
Bank Nifty Coefficient Prob.
w -1.03622
0.0000
α 0.19548
0.0000
λ
-0.14501
0.0000
β 0.888235 0.0000

339
 Dummy -0.00048 0.5873

Table 6 shows the result of EGARCH for individual banks. w is

negative and significant for all the Banks showing depressing
impact on the volatility in the market. α represents the response
of volatility to yesterday’s news The volatility is more sensitive
to market events for HDFC Bank and Union Bank of India. α is
positive for all banks except IDBI bank indicating that volatility
is negatively related to market news. λ measures the leverage
effect which means that good and bad news don’t have equal
effect on the volatility. The negative value indicates that bad
news cause greater volatility as compared to good news and
positive value shows that good news cause greater volatility as
compared to bad news. λ is negative and significant for Axis
Bank, Bank of India, Canara Bank, HDFC Bank, ICICI Bank,
Oriental Bank of Commerce and Union Bank of India. λ is
positive for IDBI Bank, PNB,Bank of Baroda (not significant)
and SBIN (not significant). β shows persistence effect which is
ranging from 0.055285 to 0.987699. The average persistence
effect is higher for private bank i.e 0.906722 as compared to
public bank i.e 0.759076. The persistence effect of IDBI Bank is
lowest which is not significant. The coefficients dummy is not

340
significant implying that market volatility is not influenced by the
introduction of futures trading.

Table 6: EGARCH

Bank w α λ β Dummy
Axis - 0.279058 - 0.905729 -
Bank 0.868713 0.046733 0.002887
(0.0000) (0.0000) (0.0016) (0.0000) (0.0215)
Bank - 0.332399 0.332399 0.855041 -
of 1.243439 0.001210
Baroda (0.0000) (0.0000) (0.0660) (0.0000) (0.4396)
Bank - 0.274219 - 0.844492 9.64E-05
of 1.270868 0.116674
India (0.0000) (0.0000) (0.0000) (0.0000) (0.9533)
Canara - - 0.809068 -
Bank 1.526188 0.270204 0.096893 0.000906
(0.0000) (0.0000) (0.0000) (0.0000) (0.5798)
HDFC - - 0.765795
Bank 2.130372 0.430365 0.104214 0.001285
(0.0000) (0.0000) (0.0000) (0.0000) (0.2195)
ICICI - 0.148922 - 0.975644 -
Bank 0.239439 0.208241 0.003629
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
IDBI - - 0.468014 0.055285 0.042998
Bank 3.606670 0.263460
(0.0000) (0.0076) (0.0000) (0.7969) (0.0019)
OBC - 0.240652 - 0.948014 -
0.548199 0.043902 0.001534
(0.0000) (0.0000) (0.0028) (0.0000) (0.2907)
PNB - 0.255942 0.073741 0.979720 -
0.309214 0.001834
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 (0.0000) (0.0000) (0.0000) (0.0000) (0.2952)
SBIN - 0.262241 0.021039 0.987699 -
0.265482 0.001778
(0.0000) (0.0000) (0.0810) (0.0000) (0.2662)
Union - 0.446199 - 0.813935 -
Bank 1.630767 0.106259 0.001577
of (0.0000) (0.0000) (0.2623)
India (0.0000) (0.0000)
Figures in ( ) represent p value

As we know that Arch LM fails to reject null hypothesis of no

ARCH effect, we will try to check volatility by using least square
method. Results are shown in Table 7.
Table 7: Least Square Method
Variable Coefficient Prob
C 0.001577 0.3952
RET(-1) 0.017835 0.5283
DUMMY -0.000924 0.7100

The lagged return doesn’t significantly affect the return. The

coefficient of dummy is not significant implying that volatility of
Kotak Mahindra Bank is not affected by introduction of future.

Conclusion
With the objective of analyzing the impact of introduction of
future trading on the spot market volatility of banking sector, we
examined the volatility behavior of Bank Nifty along with its

342
component scrips. The result shows that the volatility of Bank
Nifty is not affected by introduction of future. The present work
carried out by using Bank Nifty suggest that introduction of
future doesn’t have any stabilizing or destabilizing effect on
banking sector as experienced by other sectors. The analysis also
shows that introduction of future doesn’t affect the volatility of
most of the banks. Leverage effect is present in Bank Nifty as
well as in most of banks except Bank of Baroda and SBIN. On an
average, persistence effect is high which signifies that shocks will
take long time to die. The paper suggest that there is mixed effect
on volatility of public and private sector bank. Since this study is
carried out on banking sector, it will not be easy to generalize the
results and further research is required to evaluate how
introduction of future trading affect other sectors.

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