Chapter - I
Chapter - I
Chapter - I
INTRODUCTION
Before 1991, when Indian economy was not liberalized, the economy was
controlled and protected by number of measures like licensing system, high
tariffs and rates and limited investment in core sectors only. During 1980s,
growth of the Indian economy was highly unsustainable because it mainly
depends on borrowings to correct the current account deficit. Thus, to reduce
the imbalances, the Government of India introduced economic policy in
1991 to implement structural reforms. At that time the financial sector very
unstructured and its scope was limited only to bonds, equity, insurance,
commodity markets, mutual and pension funds.
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The traders in the market can be individuals or large corporates who can be
physically anywhere. These investors place their orders to the professionals
of a stock exchange who executes these buying and selling orders on their
behalf. The stocks are listed and traded on stock exchanges. Some exchanges
are physically located, based on open outcry system where transactions are
carried out on trading floor. The other exchanges are virtual exchanges
whereas a network of computers is composed to do the transactions
electronically.
2
global investing platform which is an internet based trading system,
BSEWEBx.co.in is now an centralized BSE trading platform which can be
accessed globally. The purpose of BSE automation and online system is to
protect the investor interests, to promote the Indian market and to encourage
innovations around the world. The BSE National Index base is 1983-84 =100
and it was started with the launch of SENSEX in 1986. It comprised 100
stocks listed at five major stock exchanges in India at Mumbai, Kolkata,
Delhi, Ahmedabad and Chennai. In 1996, the BSE National Index was
renamed to BSE-100 Index and, since then, its calculations considers the
prices of stocks listed at BSE. The "BSE-200" was launched in 2006 as the
dollar-linked version of BSE-100. At Present, the BSE-500, BSE-PSU
Index, DOLLEX-300 Index and BSE TECk Index are also operated .
The National Stock Exchange of India Limited (NSE) is the the first
demutualized electronic exchange of India which is located in Mumbai. NSE
was established in 1992 and it was the first exchange in the country to
provide a modern, fully automated screen-based electronic trading system as
it helps the traders and investors with an easy trading facility from any part
of the country. NSE operating system known as the ‘National Exchange for
Automated Trading’(NEAT) is a fully automated screen based trading
system. According to World Exchanges report, NSE has a market
capitalization of more than US $1.65 trillion, making it the world’s 12th-
largest stock exchange as of 23 January 2015. The CNX Nifty, the 50 stock
index, is popularly used as a benchmark of the Indian capital markets by the
investors.
3
Index, CNX IT index, Bank Nifty Index, Nifty Midcap 50 index and single
stock futures are available. During the financial year April 2013 to March
2014, the average daily turnover in the F&O Segment of the Exchange stood
at Rs 1,52,236 crore
4
policy makers, practitioners and economists alike. The regular frequency of
occurrence of financial crises in the last two decades and especially the
outburst of the US subprime crisis in 2008 has added authority to these
concerns.
Derivates are the financial instruments whose value is derived from the price
of an underlying item and this underlying item this underlying item can be
equity , index foreign exchange, interest rate, exchange rate, currency ,
commodity such as wheat ,gold , silver , crude, chana (gram), pepper , etc .
or any other asset.
When the like underlying in the derivative contracts are the financial
instruments or indicators like equity, index, currency, interest rate etc, they
are called as Financial Derivatives . When the underling in the derivative
contracts are commodities like gold , silver, chana, copper etc, these are
called as commodity derivatives.
5
Derivatives instruments are different from Insurance, in that they cover
general risks whereas the letter covers specific risks. Financial Derivatives
also provide an opportunity to earn profit for those persons who have higher
risk appetite. These instruments indeed facilitate to transfer the risk from
those who wish to avoid it to those who are willing to accept the same. In
the stock market, Derivatives instruments have tools. Financial Derivatives
have become increasingly popular and most commonly used in the world of
finance. The rate of growth of derivatives is so phenomenal all over the
world that now it is called as the derivatives revolution.
Derivatives are financial instruments, which derive their value from the
value of an underlying asset. This implies that Derivative instruments have
6
no independent value. The underlying asset in the derivatives contract can
be securities, commodities, bullion, currency, livestock or anything else.
7
5. In general, the Financial Derivatives are carried off-balance sheet.
The size of derivatives contracts depends upon its notional amount.
The notional amount is the amount used to calculate pay off.
8
underlying assets can be a commodity like wheat, gold, silver, crude, oil, gas
etc. whereas in case of Financial Derivatives underlying assets are stocks,
currencies, bonds and other interest rate bearing securities etc. Another way
of classifying the Financial Derivatives in into basic and complex
derivatives. In this, Forward contracts, Futures contracts and Options
contracts have been included in the basic derivatives whereas Swaps and
other Derivatives are categorized as complex because they are built up from
either Forward/Futures or Options contracts or both. In fact, such derivatives
are effectively derivatives on derivatives. (Hybrid derivatives). The features
of those Derivatives instruments are briefly presented here.
1.1.2.1 Forward
1.1.2.2 Futures
9
buyer as well as seller. Exchange sets the standards for quality, quantity,
price, quotation, date and delivery place (in case of commodity). Future
contracts being trade on organized exchanges impart high liquidity to the
transaction. The clearing house, being the counter party to the sides of a
transaction, provides a mechanism that guarantees the honoring of the
contract and ensuring very low level of default.
1.1.2.3 Options
In case of Future contract, both parties are under obligation to perform their
respective obligations out of a contract. But in and options contract, as the
name suggests, is in some sense, as optional contract. An option is the right,
but not the obligation, to buy or sell something at a stated date at a stated
price. A “call option” gives the holder the right to buy; a “put option” gives
the holder the right to sell. Options are the standardized financial contract
that allows the buyer(holder) of the options ,i.e. the right at the cost of
option premium, not the obligation, the buy (call options) or sell (put
options) a specified asset at a set price on or a before a specified date
through exchanges.
Options contracts are of two types: call options and put options. Apart from
this, options can also be classified as OTC (over the counter) options and
exchange trade options. In case of exchange traded options contract,
contracts are customized contracts traded on recognized exchange, whereas
OTC options are customized contracts traded privately between the parties.
A call options gives the holder (buyer/one who is long call), the right to buy
specified quantity of the underlying asset at the strike price on or before
expiration date. The seller (one who is short call) however, has the
obligation to sell the underlying asset if the buyer of the call option decides
to exercise his option to buy.
1.1.2.4 Swaps
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respective underlying contracts or we can say, a swap is an agreement
between two or more parties to exchange stream of cash flows over a period
of time in the future. The parties that agree to the swap are known as counter
parties. The two commonly used swaps are: i( Interest rate swap which
entail swapping only the interest related cash flows between the parties in
the same currency, and ii) 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 the cash flows in the opposite
direction.
1.1.2.5 Warrants
1.1.2.6 Convertibles
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predetermined specified terms with regards to the conversion period,
conversion ratio and conversion price.
Arbitrageurs:
o Banks
o Individuals
1.1.3.1 Hedgers
These Investors have a position (i.e. have bought stocks) in the underlying
market but are worried a boot a potential loss arising out of a change in the
assets price in the future Hedger participates in the derivatives market to
lock the price at which they will be able to transact in the future. Thus they
try to avoid price risk through holding a position in the derivative market.
Different position in the derivatives market passed on their expose in the
underlying market. A Hedger normally takes an opposite position in the
derivatives market to what he has in the underlying market.
• Short Hedge
• Long Hedge
Short Hedge
A short hedge Investors taking a short position in the future market. Short
Hedge position is taken by someone who already own the underlying assets
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or is expecting a future receipt of the underlying assets.
e,g. an investors holding Tata shares may be worried a boot adverse future
price movement and may want to hedge the price risk . He can do so by
holding a short position in derivation market. The investor can go short in
Tata future at the NSE .This protect him from price movement in Tata
Stock.
Long Hedge
A Long Hedge Involve a Long position in the future market. A long position
holds agree to buy the underlying assets at the expiry date by paying the
agree future/ following price. This strategy is used by those who will need
to acquire the underlying assets in the future.
1.1.3.2. Speculators:
A speculator is one who bets on the derivatives market based on his views
on potential movement of the underlying stock price. Speculator takes large
calculated risk at they trade based on anticipated future price movement.
They hope to make quick, large gains, but may not always be successful.
They normally have shorter holding time for their position as compared to
hedges. If they price of the underlying moves as per this expectation they
can make large profit. However, if the price moves.
1.1.3.3. Arbitrageurs
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discrepancy between the stock price in the calm and the derivatives markets.
There are three possible price scenarios at which SBI can close expiry day.
Let us calculate the profit / Loss of the Arbitrageurs in each of the scenarios
where investor had initially (august 1) purchase SBI shares in the spot
market at Rs.1780 and sold the future contract of SBI at Rs.1790.
Scenarios - I:- SBI shares closes at a price greater then 1780 ( say Rs.2000)
in the spot market on expiry day. SBI future will close at the same price as
SBI in spot market on the expiry day i.e. SBI future will also close at
Rs.2000.
Scenarios-II
SBI future will close at the same price as SBI in spot market on expiry day.
Scenarios -III SBI shares close at Rs. 1500 in the spot market on expiry day.
SBI future will close at Rs.1500, the Arbitrageurs receivers his previous
transaction entered into Aug 1,2009.
The difference between the spot and future price arose due to some
inefficiency (in the market), which was exploited by the Arbitrageurs by
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buying shares in spot in selling future. As rule and more such Arbitrageurs
trade take place, the difference between spot and future price would narrow
there by reducing and alternatives of future Arbitrageurs.
Jan 2008: trading of Chhota (Mini) Sensex at BSE & Mini Index
Futures & Options at NSE commenced.
15
Aug 2008: trading of Currency Futures commenced.
1.2 VOLATILITY
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instantaneously. Similarly, volatility has to be observed over stated periods
of time, such as hourly, daily, or weekly, say. Once it has been observed as a
time series, it is obviously interesting to know about the properties of the
series, to forecast from its own past, can the series be modeled conveniently
and the results better explained. Financial econometricians deal with these
questions and there is now a substantial and often well documented literature
in this area
There are a number of other things that cause volatility. Amongst other
things that cause volatility is arbitrage. Arbitrage is the simultaneous or
almost simultaneous buying and selling of an asset to profit from price
discrepancies. Arbitrage cause markets to adjust prices quickly assimilated
into market prices. This is a curious result because arbitrage requires no
more information than the existences of a discrepancy .
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and more kinds of financial instruments. The growing linkages of national
markets in currency, commodity and stock with world markets and existence
of common players, have given volatility a new property – that of its speed
transmissibility across markets.
The faster information is disseminated, the quicker markets can react to both
negative and positive news. Improved trading technology makes it easier to
take advantage of arbitrage opportunities, and the resulting price alignment
arbitrage causes. Finally, more kinds of financial allow investors more
opportunity to move their money to more kinds of investment positions
when conditions change.
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stock exchanges, a system called ‘circuit breakers’, getting its name from
the electricity circuit breakers.
Circuit breakers came in effect from July 2001, the NSE implements index
based Market - wide circuit breakers to ensure safety of the investors. SEBI
has partially revised the earlier guidelines on September 03, 2013.
According to the revised guidelines, the index-based market-wide circuit
breaker system is applicable at three check points of the index movement, at
10%, 15% and 20% respectively. Nationwide, the complete equity and
derivative markets trading is halted, whenever these circuit breakers are
triggered. The index based market-wide circuit breakers are triggered by
movement of any of the BSE Sensex or the NSE CNX Nifty, whichever is
breached earlier.
The trigger of circuit limits also depends on the time at which it occurs. 10%
movement in either direction
15% movement in either direction After the above mentioned halts, trading
starts again. If the market hits 10% again, there will not be any halts, but if
it breaches 15%, circuit limits comes to play again.
The above percentage is calculated on the closing value of the Sensex or the
Nifty on the last day of the immediate preceding quarter. So, for deciding
the circuit limit for the Jan-March 2014 period, the closing value of the
bellwether indices on December 31, 201 would be used.
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1.2.2.2 Pre Open Session
Pre trading /Pre open session was introduced by SEBI in July 2010 to settle
to an agreeable opening price. This was a necessary move to reduce
volatility due to an abrupt opening of the market and also to channelize the
liquidity. The opening price thus is solely the equilibrium price which is the
result of the demand & supply of the assets and is not based on the opening
trade price. Thus, the overnight news in securities is allowed to be suitably
reflected in the opening price.
As discussed earlier, the information from other parts of world has an effect
on Indian securities market. The Asian markets open before the Indian stock
market due to difference in time zone. Thus, the European and American
markets have an extended market timings. The Exchanges in these markets
have trading hours even extending up to 23 hours. This acts as risk hedging
that might arise due to global information flow. This has a considerable
advantage as the increase in market timings helps in readily assimilating the
information from markets, reduces volatility and its impact cost. There is an
advantage of trading positions over a longer time window responding to the
market movements overseas.
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Table 1.1: Market timings of various products in India
Product/Market Timing
Cash Market 9:55 am to 3:30 pm
Equity Derivatives 9:55 am to 3:30 pm
Currency Derivatives 9:00 am to 5:00 pm
Commodity Derivatives 8:00 am to 11:30 pm
Power Exchange 10:00 am to 12:00 Noon
(Source: NSE India Website)
Market Surveillance division was set up in SEBI in July 1995 and plays a
crucial role to ensure safety and market integrity by keeping a watch on the
activities of the stock exchanges. SEBI provides the market surveillance on
movements and trends and further analyzes the same. When reported about
any specific complaints regarding inside trading, preliminary inquiries are
conducted to determine events of market manipulation, insider dealing or
any other suspicious activity. In cases of confirmatory reporting of the
trading misuse, the client details and records are obtained from the stock
brokers and necessary actions are initiated.
All the stock exchanges have an elaborate margining system in the stock
market i.e. by mark to market margins, daily margins and adding limits to
intraday trading . The recent example related to market surveillance is when
former Goldman Sachs Director Rajat Gupta, convicted of insider trading.
The Securities and Exchange Commission (SEC) ordered to pay a hefty
$13.9 million civil penalty and permanently barred him from acting as an
officer or director of a public company for disclosing confidential
information.
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1.3 IMPACT OF RBI POLICIES AND GOVERNMENT POLICIES ON
STOCK MARKET
RBI, the apex institute of India which Monitors and regulate the Monetary
policy of the country stabilizes the price by controlling inflation.
Connotative interventions either have perverse effects or reversed over a
longer period. Intervention increases volatility, while changes in reserve
requirements decrease volatility in the short period. Policy variables also
effect the exchange rate itself.
The Reserve Bank of India (RBI) is India’s central bank which controls the
Reporates. Recently, in its Fourth Bi-monthly Monetary Policy Statement
2015-16 it has more or less maintained status quo by cutting Repo Rate by
50 bps at 6.75%. The cash reserve ratio (or CRR) is maintained at the same
4%. It was also announced that the Bank Rate will be maintained at 7.75%.
Why was this decision taken? The factors that could have caused this can be
low inflation, domestic factors and global factors. These decision play a
very crucial role to decide the future course of economy.
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three financial years. India’s exports shrank by 20.2 per cent to $22.35
billion in May 2015 with a decline in corporate investment[13]. Considering
this high export/GDP ratio of over 23 per cent, India can’t swim out of this
global recession crisis.
The recent amendments in the forex exchanges and stock markets by the
monetary authorities, there has been a jump in foreign investments to the
tune of Rs. 2,000 crore in the Indian capital markets so far in April 2015,
and foreign investments inflows have crossed the Rs. 81,000 crore mark
from the start of the year. Foreign portfolio investors or FPIs have bought
shares worth Rs.2,392 crore till 10 April 2015, while they pulled out Rs.337
crore from the debt markets, taking their net investment to Rs. 2,054 crore
($329 million), data compiled by Central Depository Services Ltd showed.
Market analysts explains that this large inflow is due to the reform measures
taken by the government, with an expectation of a economic revival with a
catapult growth and interest rates reported good news by showing a drop.
India in October-December quarter of FY 2013-14, has narrowed its current
account deficit to USD 8.2 billion, or 1.6% of gross domestic product. That
was lower than the deficit of USD 10.1 billion, or 2% of GDP, in the
previous quarter due to falling oil prices. Since FY 2013 to current FY 2015,
there is a reported 300 bps improvement in current account balance, due to a
sharp deceleration in consumption, economic lethargy, small investment
activity and increased government spending.
The brent crude price fall has been a boon to Indian economy which was
triggered by the global oversupply. The oil was traded at $115 per barrel just
a year ago. Due to the fall in international oil prices, there is a trend to
discontinue the subsidies in the oil products such as petrol prices and diesel
prices have been deregulated. This and many other factors leads to lower
fiscal deficit that has reduced government borrowing and with an increase in
flow towards assets resulting in productivity.
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Other Factors
Apart from the factors discussed above there are certain external factor
which can lead to volatile market. Some of them are namely:
Political Instability
This can be regarded as the single most major reason crashing the stock
market. No investors will prefer to invest in a unstable political scenario and
will definitely look for profit elsewhere. Turmoil in politics have no
explanation for an impact on the growth of companies. However, stock
markets always negatively respond to political instability.
Negative news
Economic growth
High growth sectors for economic growth are primarily the capital goods
and power sectors which also leads to a volatile market.
Profit booking
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maximum returns with minimum risk. International diversification can be an
option as rationale behind this is that stock returns within a county can be
highly correlated because of similar environment but internationally
conditions can be different. On account of different factors like economic
condition, political stability, tax and tariff rates and inflationary conditions,
there are chances that less correlation in stock returns across different
countries is possible. In recent years, the interest in country fund especially
in emerging economies has increased.
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other Asian markets has increased on Indian stock market during and after
the Asian Financial Crisis, this result gives an indication that Indian stock
market, is moving closer towards other Asian stock markets integration.
Wong et al.,(2004) highlighted that there was a trend of increasing
interdependence between most of developed markets and emerging markets
after the 1987 market crash.
After the 1997 financial crisis, the interdependence between these have gone
more intensified resulted into international diversification benefits
reduction. Bose (2005), found whether there are any common forces which
driving the stock index of all economies or there was some country specific
factors which controlling the each individual country’s economy. Indian
stock market returns were highly correlated with the returns of rest of Asia
and US during post Asian crisis and till mid 2004. Not only this, Indian
stock market influenced some major Asian stock market returns. Co
integration between India and other market in Asian region was not very
high but sufficient enough to design portfolio internationally. Huang (2013),
supported that after Asian financial crisis from 1997-1999, the stock markets
integration not getting weekend rather it improved and getting stronger.
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Industrial Average is the second oldest U.S. market index after the Dow
Jones Transportation Average. The Industrial part of the name is largely
chronological, as most of new modern 30 companies have little or nothing to
do with traditional heavy industry.
The DAX is a blue chip German stock market index of Frankfurt Stock
Exchange which consist of the 30 major German companies. DAX measures
the performance of the Prime Standard’s 30 largest German companies by
their volume and market capitalization. It is the alike FT30 and the Dow
Jones Industrial Average, but because of its small assortment it does not
essentially represent the economy as whole.
1.6.3 HangSeng
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100. In addition to the RTS Index, MICEX-RTS also computes and
publishes the RTS Standard Index (RTSSTD), RTS-2 Index, RTS Siberia
Index and seven sectoral indices (Telecommunication, Financial, Metals &
Mining, Oil & Gas, Industrial, Consumer & Retail, and Electric Utilities).
The RTS Standard and RTS-2 are compiled similarly to the RTS Index, from
a list of top 15 large-cap stocks and 50+ second-tier stocks, respectively.
1.6.5 CAC- 40
The general belief that futures trading triggers excess speculation, and
possible price instability, has been a fertile research terrain for many
scholars (Damodaran and Subrahmanyam, 1992). The implications for policy
makers and those responsible for regulating futures trading have also been
noted. The debate became more vivid after “Black Monday,” which has led
to much interest in examining volatility in modern financial markets. It is
not yet clearly established whether derivatives induce excess volatility in the
cash market and thus destabilize equity prices.
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that futures trading have raised volatility in the Japanese market, possibly
attributed to low-cost speculative opportunities.
Early evidence (Bessembinder and Seguin, 1992) points out that futures
trading improve liquidity and depth inthe cash equity market, which is
corroborated by more recent studies (Board et al., 2001). Analysis of the
FTSE100, S&P500, and DJIA indices (Robinson, 1994; Pericli and
Koutmos, 1997; Rahman, 2001) reveals either a volatility reduction in the
post futures phase or no change in the conditional volatility over the two
periods.
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period, while the opposite applies for the U.S. and Japanese equity markets
(Gulen and Mayhew, 2000). Recently, Dawson and Staikouras (2008)
investigated whether the newly cultivated platform of derivatives volatility
trading has altered the variability of the S&P500index. They documented
that the onset of the CBOE volatility futures trading has lowered the equity
cash market volatility, and reduced the impact of shocks to volatility. The
results also indicate that volatility is mean reverting, while market data
support the impact of information asymmetries on conditional volatility.
Early evidence unveils that bad news in the futures market increases
volatility inthe cash markets more than good news (Koutmos and Tucker,
1996; Antoniou et al., 1998), while post futures asymmetries are
significantly lower for major economies, except the United States and
United Kingdom. When both spot and futures markets are examined, it
seems that asymmetries run from the spot to the futures market. The
leverage hypothesis is not the only force behind asymmetries, as market
interactions, noise trading, and irrational behavior may well contribute to the
rise of asymmetries.
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tracking market movements in retrospect of a trend change. On that basis, as
futures do attract a diverse number of participants, then some form of market
destabilization may take place. Recent evidence (Antoniou et al., 2005;
Chau et al., 2008) indicates that feedback trading is either reduced or not
attributed, at least in large part, to the existence of futures markets. When
feedback trading does take place, both rational and any other
investors/speculators tend to join the trading game, which in the short run
may drive prices away from fundamentals.
On the other hand, in efficient markets and under rational expectations, the
effect of feedback trading might be limited as speculators will ultimately
start liquidating their positions, driving equity prices closer to their intrinsic
values. Finally, research has concentrated on stock indices rather than
individual shares. It is a fact, however, that individual share futures (ISFs)
are traded in modern markets, and their analysis sheds light on financial
markets’ behavior (McKenzie et al., 2001; Chau et al., 2008).It is true that
equity indices capture wide-market forces, but when it comes to identifying
the origins of a phenomenon, the large number of constituent stocks poses
an obstacle.
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1.7.1 Derivatives lead to Increase in Volatility:
The presence of noise trading can cause prices to deviate substantially from
fundamentals (DE Long et al., 1990) and give rise to jump- volatility
(Becketti and sellon Jr., 1989), i.e., occasional and sudden extreme
fluctuation in prices. Such shocks can lead to potentially destabilizing
outcomes-a highly volatility environment with abrupt price swings would
result in a high probability of market bubbles and crashes.
Another positive effect of this is that the domination of the futures markets
by rational investors will lead to a boost in the liquidity of spot markets,
thus reducing market frictions at the spot level. The volatility which is of
major concern in volatility due to noise traders. Futures market provides
him/her with an additional route to apply his/her non-fundamental trading
32
strategies. If the future’ prices are “wrong” (over- or under-priced), this will
be reflected into the underlying spot market, affecting pricing there too. The
wild swings in prices irrespective of fundamentals expected will tend to
amplify volatility at the spot market level, enhancing its riskiness.
The model developed by Froot and Perold (1991) demonstrates that futures
market cause an increase in the market depth due to the presence of more
market makers in the futures segment than in the cash market and the more
rapid dissemination of information. Volatility decreases since there is more
rapid processing of information.
Many author, e.g., Anthony, Miller, Homes and Tomset also suggest that
market participants prefer trading in the derivatives market as compared to
the trading in the spot market, because of market frictions like transaction
costs, capital requirements, etc. These factors are also mentioned by Faff
and Hiller to suggest that speculators have an incentive to migrate to the
derivatives market and move their ‘ risky’ deeds to the derivatives markets,
thus causing some reduction in noise in the market and leading to lower
volatility in the underlying market.
Now the question is why are we so concerned about the stock market
volatility? Does the stock market affect the economy? If yes, how?
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when share prices fall? How does it impact on the average consumer? And
how does it affect the economy?
Where: S.D. = ∑ (r t − r t )2
n −1
i= the day identifier for the month (i.e. for a month, I goes from 1 to 30 or 31)
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By using standard deviation, the assumption, that all past prices have an
equal relevance in the shaping of the volatility of the future is applied.
Intuitively this assumption is too crude as more recent volatility is likely to
have more relevance that of several years ago and should hence be given a
relatively higher weight in the calculation.
A simple way to counter this problem is done by only using the last 30 days
to calculate the historical volatility and this model is actually widely used by
actors in the financial markets. The model weights volatility older than 30
days as 0 and puts equal weight on the volatility of the last 30 days.
This model is however still crude and more sophisticated models are
frequency used moving into the area covered by models such as the
Exponential Weighted Volatility models. If we are interested in what the
volatility is this instant, the standard deviation as a measure is of little use.
Stock prices volatility has received a great attention from both academicians
and practitioners over the last two decades because it can be used as a
measure of risk in financial markets. over recent years, there has been a
growth in interest in the modelling of time-varying stock return volatility.
Many economic models assume that the variance as a measure of uncertainty
is constant through time. However, empirical evidence rejects this
assumption. Economic time series have been found to exhibit period of
unusually large volatility followed by periods of relative tranquility (Engle,
1982). In such circumstances, the assumption of constant variance
(homoskedasticity) is inappropriate (Nelson, 1991).
The time series are found to depend on their own past value
(autoregressive), depend on past information (conditional) and exhibit non-
constant variance (homoskedasticity). It has been found that the stock
market volatility changes with time (i.e., it is “time-varying”) and also
exhibits positive serial correlation or “volatility clustering”. Large changes
tend to be followed by large changes and small changes tend to be followed
35
by small changes, which mean that volatility clustering is observed in
financial returns data. This implies that the changes are non-random. Theses
characteristics of time series data can be captured by ARCH/ GARCH
models.
Autoregressive Model:
36
where
b 0 is the constant
b 1 is the weight
e t = error term
ARMA Model:
y t = b 0 + b 1 Y t-1 +α1 e t +e t
An ARMA model with (p) lags of yt and (q) lags of et will be called as
ARMA (p.q) model.
The weakness with simple variance is that all returns get the same weight.
So we face a classic trade-off: we always want more data but the more data
we have the more our calculation is diluted by distant (less relevant) data.
The exponentially weighted moving average (EWMA) improves on simple
variance by assigning weights to the periodic returns. By doing this, we can
both use a large sample size but also give greater weight to more recent
returns. EWMA method, which is, in effect, a restricted version of the
ARCH model of Engle (1982). This approach forecasts the conditional
variance at time t as a linear combination of the lagged conditional variance
37
and the squared unconditional shock at time (t-1). The EWMA model
calculates the conditional variance as:
σ t2 = λσ t2−1 + (1 − λ )ε t2−1
Where λ is the decay parameter.
Prior to the ARCH model introduced by engle (1982), the most common way
to forecast volatility was to determine the standard deviation using a fixed
number of the most recent observations. As we know linear models are
based on certain assumptions and when these assumptions are violated, we
use non linear models such as ARCH/ GARCH.
The variance of time series data is not constant, i.e. homoskedastic, but
rather a heteroskedasticity process, it is unattractive to apply equal weights
considering we know recent events are more relevant. Moreover, it is not
beneficial to assume zero weights for observation prior to the fixed
timeframe. The ARCH model overcomes these assumption by letting the
weights be parameters to be estimated there by determining the most
appropriate weight to forecast the variance. The conditional volatility
models such as ARCH & GARCH in corporate time varying second order
movement, where the series at any time period t is decomposed into its
conditional mean and conditional variance. Both conditional mean and
conditional variance depends all past information available up to period t-1.
the acronym ARCH stands for Autoregressive Conditional Heteroske-
dasticity. The term Heteroskedasticity” refers to changing volatility (i.e.
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variance). But it is not the variance itself which changes with time according
to an ARCH model: rather, it is the conditional variance which changes in a
specific way, depending on the available data. The conditional variance
quantifies uncertainty about the future observation.
An ARCH (1) model, where the conditional variance depends only on one
lagged square error term, is given by:
h t = α0 +α1 e 2 t-1
where
h t = conditional variance
α0 = constant term
α1 = weight
ARCH shortcomings
Even though the ARCH model is useful but has its own shortcomings. For
instance, we do not know how many lags, p. we should apply for the best
results. The potential number of lags required to capture all of the
dependence in the conditional variance could be very large thus making the
model not very parsimonious.
Intuitively, the more parameters we have in the model, the more likely it
will be that one of them will have a negative estimated value.
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The GARCH specification, firstly proposed by Bollerslev (1986), formulates
the serial dependence of volatility and incorporates the past observations
into the future volatility.GARCH model was first used to model the
autoregressive and time varying nature of Inflation.
GARCH model overcomes the limitations of the ARCH model. Unlike the
ARCH model, the Generalized Autoregressive Centralized
Heteroskedasticity model (GARCH), introduced by Bollerslev (1986) only
has three parameters that allows for an infinite number of squared errors to
influence the current conditional Variance. This makes it much more
parsimonious than the ARCH model which is why it is widely employed in
practice. Like the ARCH model, the conditional variance determined
through GARCH is a weighted average of past squared residuals. However,
the weights decline gradually but they never reach zero. Essentially, the
GARCH model allows the conditional variance to be dependent upon
previous own lags. Using the GARCH approach, the conditional standard
deviation is the measure of volatility and distinguishes between the
predictable and unpredictable elements in the price process.
This leaves only the Stochastic component and is hence a more accurate
measure of the actual risk associated with the price.
σ2 t = α o + α 1 e t2−1 + β 1 σ t2−1
GARCH Shortcomings
Though, in most of the cases, the ARCH and GARCH models are apparently
successful in estimating and forecasting the volatility of the financial time
series data, they cannot capture some of the important features of the data.
The most interesting feature not addressed by these models is the leverage
effect where the conditional variance tends to respond asymmetrically to
positive and negative shocks in returns. They fail to capture the fat-tail
property of financial data. This has lead to the use of non-normal
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distributions (Student-t, Generalized Error Distribution and Skewed Student-
t ), within many nonlinear extensions of the GARCH model which have been
proposed. Such as the Exponential GARCH (EGARCH) of Nelson (1991)
the so-called GJR model of Glosten, Jagannathan, and Runkle (1993) and the
Asymmetric Power ARCH (APARCH) of Ding, Granger and Engle (1993),
to better model the fat-tailed (the excess kurtosis), skewness and leverage
effect characteristics.
The symmetric GARCH class models only considered the magnitude of the
returns, but not the direction. Investors act differently depending on whether
a share moves up or down which is way volatility is not symmetric in
relation to directional movements. Market declines forecast higher volatility
than comparable market increases. This is referred to as the leverage effect.
Both ARCH and GARCH failed to capture this fact and as such may not
produce accurate forecasts. Resend models building on ARCH and GARCH
such as the Threshold ARCH (TARCH), Exponential GARCH (EGARCH)
model have tried to overcome this problem. However, in the present study
we are not concerned about the asymmetries of the data. The study utilizes
GARCH (1,1) equation to model the volatility of the Indian stock market.
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A lot of studies have been made to study the effect of Financial Derivatives
on stock market volatility. Not many studies analyses the impact of
Financial Derivatives trading in individual stocks on the volatility of the
underlying. The studies which have been made previously produced mixed
results. The results varied depending on the time period studied and the
country studied.
Most of the studies made earlier considered a short time frame for study.
This study makes an attempt to provide generalizations about the impact of
derivatives on stock market volatility in India by studying the nature of
volatility over a longer frame of time the present study is focused to know
the impact of Financial Derivatives on the volatility in India. It also
addresses the issue of whether introduction of Financial Derivatives have
not been the only factor responsible for the change in volatility or there are
other factors which affect the volatility of the stock market. It also further
issues of impact of RBI polices and international events also responsible for
the change in volatility. In India , trading in derivatives contracts has been
in existence for the last fifteen years, which is a substantial time period to
provide some major input on its implications.
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