Chapter - I

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CHAPTER - I

INTRODUCTION

Financial market of a country signifies the financial strength of its economy.


Good financial health of a country helps in enhancing the cash flows and
creates capital, which contributes to development of the country. After
privatization and globalization, financial market has entered into a new
segment of global integration and liberalization with lots of new and
innovative financial instruments.

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.

A regulatory authority named as SEBI (Security Exchange Board of India)


was introduced to structure the security market and first electronic exchange
National Stock Exchange was also set up. The reason behind this was to
regularize investments, mobilization of resources and to give credit.
According to Mark Twain, “the world is divided into two kinds of people:
those who have seen the famous Indian monument, the Taj Mahal, and those
who haven’t”. The same is true for the investors which are of two kinds: the
one who are educated about the investment opportunities and the ones who
are not. India may be a small underdeveloped nation to the western world,
the market opportunities is tremendous. A stock market is a place where
buyers and sellers of stocks come together, physically and in modern
scenario virtually.

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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.

The whole system is order-driven. The order placed by an investor is


automatically matched with the best limit order. This system provides more
transparency as it shows all buy and sell orders. The Indian stock market
mainly functions on two major stock exchanges, the BSE(Bombay Stock
Exchange) and NSE(National Stock Exchange). In terms of market
capitalization, BSE and NSE have a place in top five stock exchanges of
developing economies of the world.

Bombay Stock Exchange

The Bombay Stock Exchange (BSE), established in 1875, is an Indian stock


exchange located in Mumbai. Bombay Stock Exchange is the world’s 10th
largest stock market by market capitalization at $1.7 trillion as of 23 January
2015. As on today, there are more than 5,000 companies listed on BSE.
Indian Government under the Securities Contracts Regulation Act
recognized the BSE in 1957. BSE SENSEX index was developed as a means
to measure overall performance of the exchange which was started in 1986.
In early 2000, the derivatives market was linked to this index and the
SENSEX futures contracts trading started. BSE expanded its trading
platform to options and equity derivatives. Earlier, BSE was an open outcry
floor trading exchange and later it switched to an electronic trading system
in 1995.

This automated, screen-based trading platform called BSE On-line trading


(BOLT) has a capacity of more than 5 million orders per day. The BSE has a

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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 .

National Stock Exchange

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.

NSE offers trading in Equities, Derivatives as well as in Debt. In June 2000,


the National Stock Exchange of India Limited (NSE) started trading in
derivatives by launching index futures. The segment of futures and options
of NSE is internationally renowned. In this segment, trading in CNX Nifty

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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

In 2013, in order to provide a liquid and transparent trading platform, NSE


launched India’s first dedicated debt platform. It helps the retail investors to
invest in corporate bonds through this transparent exchange platform.
Similarly, corporate bonds holders can make use of this platform. When
corporate sector decide to issue the bonds, the demand is met through this
platform to buy and sell at optimum prices. NSE was set up by a group of
leading Indian financial institutions with the help of the government of India
so that the Indian capital market can follow a transparent system.

Based on the recommendations laid out by the government committee, NSE


has been established with a diversified shareholding comprising domestic
and global investors. NSE has also helped in creation of the National
Securities Depository Limited (NSDL) which allows investors to
electronically hold and transfer their shares and bonds by secure means. This
has eliminated the handling of paper based securities therefore, the holding
the equities has become more efficient. The NSDL’s efficiency,
transparency, lower operation cost and increased security that NSE offered,
has increased the preference of the Indian stock market to international
investors as well.

The stock market is unpredictable as the stock prices change quite


frequently. Besides this, a financial market is place which provides a place
for investment and helps in enhancing the income in terms of return.
Against the background of these sweeping changes an intense academic and
public debate has begun trying to assess whether these changes provide
economic benefits or constitute a threat to financial market stability. It has
raised concerns about the economic impact of these new instruments among

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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.

Integration of economies world over has brought in multiple growth in the


volume of international trade and business. This in turn has led to increase
in the demand for international money and need of innovative financial
instruments both at national and global level. Changes in the interest rates,
exchange rates and equity prices in different financial markets led to
increase in the volatility and manifold increase in the financial risk to the
individual as well as institutional investors. Adverse changes in these
variables have been threatened the very survival of the business world. To
manage these risks, new financial instruments have been developed in the
financial market, which are popularly known as Financial Derivatives .

The basic purpose of Financial Derivatives is to provide commitments to


prices for future dates for giving protection against adverse movements in
the future prices of underlying assets thereby reduce/manage/control the
extent of financial risk. Derivatives allow investors to establish, at low cost,
return distributions that match up with their levels of risk aversion.

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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.

In India, derivatives were introduced in a phased manner after the


recommendations of in L.C. Gupta Committee Report in 1997. Futures,
Forwards, Options and Swaps are variants of derivative contracts and these
can be further combined with each other or with traditional securities and
loan to create hybrid instruments.

Derivatives trading started in Indian markets on 9 th June 2000 with the


launch of futures contracts in BSE Sensex on the Bombay Stock Exchange
(BSE). Derivatives trading started at NSE on 12 th June 2000. At the outset,
only Index Futures were introduced, Stock futures, stock options and index
options were all prohibited. in June 2001, index options trading commenced
Stock options trading started in July 2001 and stock futures trading started
in November 2001 .Thus, the full set of equity derivatives products was only
available in November 2001, Spectral indices were permitted for derivatives
trading in December 2002 . During December 2007 SEBI permitted Mini
Derivative (F&O) contract on Index (Sensex and Nifty). Further, in January
2008, longer tenure Index options contracts and Volatility Index and in April
2008, Bond index was introduced. in addition to the above ,during August
2008 , SEBI permitted Exchange traded Currency Derivatives.

1.1 CONCEPT OF DERIVATIVES

Derivatives are financial instruments, which derive their value from the
value of an underlying asset. This implies that Derivative instruments have

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no independent value. The underlying asset in the derivatives contract can
be securities, commodities, bullion, currency, livestock or anything else.

As per the Securities Contracts (Regulation) Act 1956 “Derivative” includes.

1. Security derived from a debt instruments, share, loan whether


secured or unsecured, risk instrument or Contract for differences or
any other form of security.

2. A contract, which derives its value from the prices, or index of


prices of underlying securities.

1.1.1 Characteristics of Derivatives

1. The derivatives instrument relates to the future contract between two


parties. It means there must be a contract binding on the underlying
parties and the same to be fulfilled in future. The future period may
be short or long depending upon the nature of contract.

2. Normally, the derivatives instruments have the value, which is


derived from the values of underlying assets, such as agricultural
commodities, metal, financial assets, intangible assets, etc. Value of
underlying instruments. Sometimes, it may be nil or zero, but never
less than zero.

3. Generally, counter parities have specified obligation under


derivatives contract. Obviously, the nature of obligation would be
different as per the type of instrument of derivatives. For example,
the obligation of the counter parties, under forwards, future
contracts are different from the obligations in options contracts.

4. The derivatives contract can be undertaken directly between two


parties or through a particular exchange like financial future
contracts. The exchange –traded derivatives such as Futures and
Options are quite liquid and have low transaction costs in
comparison to the tailor made contracts like Forwards.

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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.

6. In derivatives trading, transactions are mostly settled by taking


offsetting position in the derivatives themselves.

7. Derivatives are also known as deferred delivery and deferred


payment instrument. It means that it is easier to take short or long
position in derivatives in comparison to other assets or securities.
Further, it is possible to combine them to match specific
requirements, i.e., they are more easily amenable to financial
engineering.

8. Derivatives are mostly secondary market instruments and have little


usefulness in mobilizing fresh capital by the corporate world.
However, warrants and convertibles are exception in this respect.

9. Although in the market, the standardized, general and exchange-


traded derivatives are being increasingly evolved, still there are so
many privately negotiated, customized and over the Counter (OTC)
trade derivatives in existence. They expose the trading parties to
operational risk. Counter-party risk and legal risk. Further, there
may also be uncertainly about the regularity status of such
derivatives.

10. The derivatives instruments, sometimes, because of their off-balance


sheet nature, can be used to clear up the balance sheet. For example,
a fund manager who is restricted from taking particular currency can
buy a structured note whose coupon is tied to the performance of a
particular currency pair.

1.1.2 Types of Derivatives

Broadly, Derivatives can be classified in to two categories Commodity


Derivatives and Financial Derivatives . In case of commodity derivatives,

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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

A forward contract is an agreement between two parties to buy or sell as


assets at a specified point of time in the future. In case of a forward contract
the price which is paid/received by the parities is decided at the time of
entering into contract. It is the simplest form of derivatives contract mostly
entered by individuals in day-to –day life. Forward contract is a cash market
transaction in which delivery of the instrument is deferred until the contract
has been made. Although the delivery is made in the future, The price is
determined on the initial trade date. One of the parities to forward contract
assumes a long position (buyer) and agrees to buy the underlying asset at a
certain future date for a certain price. The other party to the contract known
as seller assumes a short position and agrees to sell the asset on the same
date for the same price. The specified price is referred to as the delivery
price. The contract terms like delivery price and quantity are mutually
agreed upon the parties to the contract.

1.1.2.2 Futures

Future is a standardized Forward contact to buy (long) or sell (short) the


underlying asset at a specified price at a specified future date through a
specified exchange. In the Futures, contracts the exchange will act as a

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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

A swap can be defined as a barter or exchange. It is a contract whereby


parties agree to exchange obligations that each of them under their

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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

Warrants and Convertibles are other important categories of Financial


Derivatives , which are frequently traded in the market. Warrants is just like
an option contract where the holder has the right to buy the shares of a
specified company at a certain price during the given time period. In other
words, the holder of a warrant instrument had the right to purchase a
specific number of shares at a fixed price in a fixed period from an issuing
company. If the holder exercised the right, it increases the number of shares
of the issuing company, and thus, dilutes the equities of its shareholder.
Warrants are usually issued as sweeteners attached to senior securities like
bonds and debentures so that they are successful in their equity issue in
terms of volume and price. Warrants can be detached and traded separately.
Warrants are highly speculative and leverage instruments, so trading in the
them must be done cautiously.

1.1.2.6 Convertibles

Convertibles are hybrid securities, which combine the basic attributes of


fixed interest, and variable return securities. Most popular among these
convertible bonds, Convertible debentures and convertible preference
shares. These are also called equity derivatives securities. They can be fully
or partially converted into the equity shares of the issuing company at the

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predetermined specified terms with regards to the conversion period,
conversion ratio and conversion price.

1.1.3. Market Participants and Makers:

The following enter into derivative contracts either as hedgers, speculators


or

Arbitrageurs:

o Banks

o Producers/ Corporations/ Traders/ Farmers

o Financial Institutions like Insurance companies, Investment


Banks, Merchant Banks

o Exporters and Importers

o Individuals

o Governments: National, State, Local

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.

Hedging in future market can be done trough two position.

• 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.

Another example , a sugar manufacturing company could Hedge against any


probable loss in the future due to fall in the price of sugar by holding a short
position in the futures forwards market of the price of sugar fall, The
company may loss on the sugar sale but the loss will be offset by profit
mode in the future contract.

 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

Arbitrageurs attempt to profit from pricing inefficiencies in the market by


making simultaneous traders that offset each other and capture a risk for
profit. An Arbitrageurs may also seek to make profit in case there is price

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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.

Profit/loss in spot market = 2000-1780 = Rs. 220 (Profit)

profit/loss in future market = 1790-2000 = Rs.210 (Loss)

Net Profit = 220-210 = Rs.10

Scenarios-II

SBI share close at Rs.1780 in the spot market on expiry day.

SBI future will close at the same price as SBI in spot market on expiry day.

Profit/Loss in spot market = 1780-1780 = Nil

Profit/Loss in future market = 1790-1780 = 10

Net Profit on both transaction = 0+10 = 10

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.

Profit/Loss in spot market = 1500-1780 = (-280) Loss

Profit/Loss in future market = 1790-1500 = 290 (Profit)

Net Profit on both transaction Combined = -280+290 = 10 (Profit)

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.

1.1.4. Chronology of Events leading to Derivatives Trading in India

 1956: Enactment of the securities contracts (Regulation) Act which


prohibited all options in securities.

 1969: Issue of notification which prohibited forward trading in


securities.

 1995: Promulgation of the Securities Laws (Amendment) Ordinance


which withdrew Prohibitions on options.

 1996: Setting Up of L.C. Gupta Committee to develop regulatory


framework for derivatives trading in India.

 1998: Constitution of J.R. Verma Group to develop measures for risk


containment for derivatives.

 2000: Withdrawal of 1969 notification

 May 2000: SEBI granted approval to NSE and BSE to commence


trading of derivatives

 June 2000; Trading in Index futures commenced.

 June 2001: Trading in equity index options commenced. Ban on all


deferral products imposed.

 July 2001: trading in stock options commenced. Rolling settlement


introduced for active derivatives.

 Nov 2001: trading in stock futures commenced.

 June 2003: trading of Interest Rate Futures commenced.

 Sept 2004: trading in Weekly Options started at BSE.

 Jan 2008: trading of Chhota (Mini) Sensex at BSE & Mini Index
Futures & Options at NSE commenced.

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 Aug 2008: trading of Currency Futures commenced.

 October 2008 : Trading of Currency Futures at BSE

 September 2010 : United Stock Exchange

1.2 VOLATILITY

Volatility is an important input parameter to many important finance


modeling and forecasting applications such as investment, portfolio
management, option pricing, hedging, and risk management. The estimation
of volatility is the purpose and scope of this research. It is also referred as
the spread of all likely outcomes of an uncertain variable. Typically, in
financial markets, we are often concerned with the spread of asset returns.

Volatility in financial markets has been a growing area of interest to


financial analyst who are trying to model the market dynamics. It has gained
importance among the policy makers and market traders, investors and risk
managers because it can be used for risk mitigation and analysis. According
to Poon, “Primarily, the volatility receives a great deal of concern from
financial market participants because greater volatility in the stock, bond
and foreign exchange markets raises important public policy issues about the
stability of financial markets”. For example, Garner (1990) finds that the
stock market crash in 1987 reduced consumer spending in the USA. Maskus
(1990) finds that the volatility in foreign exchange markets has an impact on
trade. Volatility forecasting is very important in risk management and
portfolio management and also crucial in pricing an option. Nowadays,
volatility itself has become the subject of trading. There are now exchange-
traded contracts which are written on volatility. Financial market volatility
also has a wider impact on market regulation, monetary policy and public
issues. Therefore, there is a need of research in financial market volatility
modeling and hence forecasting.

Volatility is a random variable, which has to be measured over a period of


time, rather than a observed variable which can be measured

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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

1.2.1. Causes of Volatility

The stock market volatility is caused by number of factors such as change in


inflation rate, financial leverage, corporate earnings, dividends yield
policies, bonds prices and many other macroeconomic, social and political
variable such as international trends, economic cycle, economic growth,
budget general business condition, credit policy etc. volatility is driven by
trading volume followed by arrival of new information regarding new floats,
or any kind of private information that incorporate into market stock prices.

Volatility of returns in financial markets can be a major stumbling block for


attracting investment in small developing economies. High returns and low
level of volatility is taken to be a symptom of a developed market. India
with long history and China with short history, both provide as high a return
as the US and the UK market could provide but the volatility in both
countries is higher (M.T. Raju, Anirban Ghosh, 2004).

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 .

Another obvious reason for market volatility is technology. This includes


more timely information dissemination, improved technology to make trades

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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.

Due to liberalization of the global markets, the domestic market is affected


not just by its own force or internal factors but the global factors too, make
an equal impact. The global economic slowdown in September 2008 is the
biggest instance of such an interlink age. The Indian economy was fully
affected by the US housing bubble.

Another reason for market volatility is speculation. Speculation is the act of


trading is an asset, or conducting a financial transaction, that carries
significant risk of loosing most or all of the initial outlay, in expectation of a
substantial gain. This involves buying and selling of financial instrument
and make money from the anticipated price fluctuation. Speculation causes
deviation of price from their intrinsic value.

1.2.2 Measures to control Volatility

The following measures have been adopted to control volatility:

1.2.2.1 Circuit Breakers

As discussed in previous section, stock prices can move in either direction


due to various logical reasons, such as, investments, government policies,
market conditions etc. Adversely, stock prices responds drastically due to
manipulation, greed by speculators and investor’s fear. In order to control
such harmful movements of price fluctuations, there is a fail-safe in the

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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

 If the movement is before 1 pm - 45 minutes halt

 If the movement is after 1 pm but before 2:30 pm - 15 minutes halt

 If the movement is after 2.30 pm - no halt

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.

 If the movement is before 1 pm - 1hour 45 minutes halt

 If the movement is after 1 pm but before 2 pm- 45 minutes halt

 If the movement is after 2 pm - remainder of the day

20% movement in either direction On resumption, if the market hits 20%,


trading will be halted for the remainder of the day.

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.

19
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.

The pre-open session is scheduled for 15 minutes starting from 9 AM and


lasting at 9:15 AM. This duration is sub divided into three parts: First, order
entry, modification, cancellation is for 8 minutes. Second, order matching
and trade confirmation is allowed for 4 minutes and remaining 3 minutes are
allotted as buffer for trade transition. All BSE Sensex and NSE Nifty
securities form part of the pre-trading Session.

1.2.2.3 Increase in Market timings

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.

A comparison of market timings of various products/markets is shown in


table.

20
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)

1.2.2.4 Market Surveillance

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.

There is a provision of risk containment which ensures safety of market as a


system.

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.

21
1.3 IMPACT OF RBI POLICIES AND GOVERNMENT POLICIES ON
STOCK MARKET

1.3.1 RBI Policy

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.

According to the RBI governor Raghuram Rajan, while remarking against


the competitive monetary easing by central banks, he commented that world
economy is going for recession. This may be true in light of, China’s trade is
showing poor data in terms of growth. West Asia is struck and is looking for
some solution to deal with subdued crude price. Brazil and Russia are
expected to post negative GDP growth. Japan is reporting a risk of inflation.
Nothing adverse has been reported by the US because of comfortable
employment data.

If we look at the India reports, the corporate sector performance is worst in


FY 2014-15. Monsoon still remain to be inconsistent. Industry output (IIP)
grew by 2.7 per cent (y-o-y) in May compared to 4.1 per cent (y-o-y) in
April 2015. India’s export is stagnant at around $300 billion since the last

22
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.

1.3.2 Government Policies

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.

23
 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

A havoc is bound to be created in stock markets when markets start to rise


unexpectedly within a short time, thus creating negative news. Markets
negative news like rise in crude prices, dollar appreciation, fed rate cut and
US visa restrictions had showed slowdown in economic growth.

 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

Investor sometimes book profits just before every crash whether it is in


2000, 2006 or 2008. However, there is a equal number of investors losing
money in every crash.

1.4 INDIAN AND INTERNATIONAL STOCK MARKETS

In the present era of liberalization, privatization and globalization, the


international investments and diversification of portfolio internationally is
an important issue, especially in the time period when stock markets are
highly volatile. Normally, people invest in the stock market with the purpose
of earning returns. An investor designs his portfolio in which he includes
different stocks or group of stock on sectoral basis to achieve his purpose of

24
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.

Emerging markets are an attractive place for investment because of various


reasons like open market system, liberal guidelines towards Foreign Direct
Investment and Foreign Institutional Investment. At the time of allocation of
the funds in internationally diversified portfolio, an investor would like to
compare returns and risk across different countries. The benefit of
internationally diversified portfolio can be enjoyed only when there is less
correlation between international stock markets. Further, while constructing
internationally diversified portfolio of securities, the correlation in the
returns of stocks from two different countries required to be calculated.
According to a report by Morgan Stanley, Indian markets are about three
times more volatile as compared to other emerging markets and almost five
times more than the volatility in developed markets. Other emerging markets
such as China, Brazil and Russia have very less volatility in comparison to
Indian market.

1.5 CONTRIBUTION OF DEVELOPED AND EMERGING ECONOMIES


IN FINANCIAL CRISIS:

A Controversial Issue after Financial Crisis, whether the integration between


emerging and developed economies has increased or not, this issue is always
get attention from researchers and academicians. Few studies are in favor
that integration between developed and emerging economies has increased
after the financial crisis. Bahng (2003), who found that the influence of

25
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.

1.6 EMERGING AND DEVELOPED ECONOMIES INDICES

A brief introduction of some indices from emerging economies and


developed economies is given as follow:

1.6.1 DJIA (Dow Jones Industrial Average)

The Dow Jones Industrial Average is an index which is created by Wall


Street Journal editor and Dow Jones & Company co-founder Charles Dow. It
is at present owned by S&P Dow Jones Indices. It was first published on
February 16, 1885. The averages are named after the name of Charles Dow
and one of his business associates, statistician Edward Jones. It shows how
30 large publicly owned companies based in the United States have done in
trading during a standard trading session in the stock market. Dow Jones

26
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.

1.6.2 DAX (Deutscher Aktien IndeX)

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

The HangSeng Index is a free float-adjusted market capitalization index. It


is a weighted stock market index in Hong Kong. It is basically used to
record and observe daily variation in the prices of the largest companies of
the Hong Kong equity market. In Hong Kong, this is the main indicator of
the overall market performance in Hong Kong. The 48 component
companies of Hang Seng represent about 60% of market capitalization of the
Hong Kong Stock Exchange. It was started on November 24, 1969, and
HangSeng Indices Company Limited is currently maintaining and compiling
the index. Hang Seng Indices Company Limited is a wholly owned
subsidiary of Hang Seng Bank, which is one of the largest banks listed in
Hong Kong in terms of market capitalization.

1.6.4 RTSI (Russia Trading System)

The RTS Index (Russia Trading System) is a free-float capitalization-


weighted index of 50 Russian stocks traded on the Moscow Exchange in
Moscow, Russia. The RTS Information Committee reviews the list of stocks
in every three months. The RTS Index value is calculated in a real-time
mode. The index was introduced on September 1, 1995 with a base value of

27
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 CAC-40 index is regarded as the benchmark index for the


performance of the Paris stock exchange. The CAC-40 index is a "Free-float
market capitalization" weighted index. This index is almost exclusively
composed of French-domiciled companies, a boot 45% of its listed shares
are owned by foreign investors. Market capitalization measurement is based
on the free float of issues shares and the index requires a minimum float of
15%. CAC 40 was officially borne June 15, 1988 and its base value was
1000 points.

1.7 DERIVATIVES AND VOLATILITY

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.

Financial bubbles along with the existence of speculators have been


addressed (Edwards, 1988a,1988b; Harris, 1989; Stein, 1987, 1989) as other
potential sources of excess price variability. It is alsotrue that closer to the
expiration day, traders attempt to settle their contracts, close their trading
positions, and aggressively arbitrage on price differences. Miller(1993) finds

28
that futures trading have raised volatility in the Japanese market, possibly
attributed to low-cost speculative opportunities.

Derivatives also increase market liquidity and expand the investment


opportunity set at lower transaction costs and margin requirements.
Exchange traded derivatives are more centralized, enabling participants to
trade and communicate their information more effectively. Assuming that
derivatives do attract rational traders, then equity prices should move closer
to their fundamentals and markets should become less volatile. Based on
intraday data, Schwert (1990) shows that the equity cash market is 40% less
volatile than its counterpart futures market, while Merton (1995) argues that
the volatility’s asymmetric response to the arrival of news is reduced in the
presence of futures markets. Yet, anecdotal evidence both supports and
refutes the aforesaid hypotheses.

Moreover, tightening any regulatory framework in the derivatives market is


not empirically endorsed. With the lack of a clear-cut theoretical background
that justifies market realities, the question becomes an empirical one. At
times, when fluctuations are large, they can easily callinto question the
collective rationality of the market. he issue is whether volatility isa sign of
collective irrationality or is consistent with the kind of fluctuations expected
to arise naturally from the actions of less informed investors.

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.

Elsewhere, findings indicate that twenty-three international stock indices


exhibit either a reduction or no change in volatility during the post-futures

29
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.

Finally, comparisons with the UK and Japanese indices, which have no


volatility derivatives listed, show that these indices exhibit higher variability
than the S&P500. The dynamic interaction between derivatives and cash
equity markets engulfs the issue of volatility asymmetricresponse to the
arrival of news (Engle and Ng, 1993). In other words,the market participants
react differently upon the arrival of bad and good news. The information
transmission mechanism, from futures to spot market, is yet unclear. The
role of asymmetries in the futures market will have implications for the
effectiveness of policy frameworks at both an institutional and a state level.

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.

Analysts and traders use techniques such as portfolio insurance, sentiment,


and other technical indicators, as well as extrapolative expectations that are
in line with the positive feedback trading approach. The latter calls for

30
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.

Liquidity is another motive behind such an analysis, as indices are more


liquid than individual stocks, amplifying any possible impact of stock index
futures on the underlying asset. At the same time, the under-lying asset on
stock index futures is not traded as opposed to Individual Stock Futures
(ISFs), making the latter an apt alternative for investigation. In a multi
aspect examination, McKenzie et al. (2001) study the systematic risk,
asymmetries, and volatility of ISFs. Their stock-specific empirical findings
add to the mixed results of the ongoing literature. They detect a clear
reduction in beta risk and unconditional volatility, during the post-IFS
listing, and offer some mixed evidence regarding the change in conditional
volatility, while asymmetric response is not consistent across all stocks.

31
1.7.1 Derivatives lead to Increase in Volatility:

Increase in volatility in spot market due to further market can be attributed


to both rational & uninformed traders. However, volatility due to informed
traders is not harmful. Informed investors rationally process all
fundamentals-related information such as earning, dividends, cash flows and
so on and condition their trades upon it which increase volatility,. On the
other hand, uninformed traders, trade on information other hand
fundamentals which increase volatility.

This type of trading strategy based on non fundamental indicators, including


for example, technical analysis and investor-sentiment. The presence of
noise trading is really a concern to the policy makers.

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.

In the absence of noise traders, volatility would be expected to follow a


more normal pattern in its distribution, which Becketti and Sellon Jr. (1989)
have termed “normal volatility”. From a practical perspective, such an
increase in volatility should be welcome; since the dominance of rational
investors in futures markets would suggest that any deviations from the
fundamentals at the spot level would be arbitraged away, leading to greater
stabilization in capital markets.

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.

1.7.2 Derivatives lead to Decrease in volatility:

Derivatives not only lead to increase in volatility but have a stabilizing


effect too. Index futures reduces volatility and stabilizes the cash market by
providing low cost contingent strategies that enable investors to minimize
portfolio risk by transferring speculators from the spot to the futures market.
Index futures enable investors to trade large volume at lower transaction
costs, improving risk sharing and thereby reducing volatility (cox, 1976;
Stein 1987; Ross, 1989, Chan et al., 1991).

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?

With plummeting share prices making headline news, it is worth considering


the impact of the stock market on the economy. How much should we worry

33
when share prices fall? How does it impact on the average consumer? And
how does it affect the economy?

1.8 MEASURING VOLATILITY

Measuring volatility present some problems, even simple measures of


volatility are relatively complex. Further, any measurement of volatility
requires a lot of information. Consequently, using any measure of volatility
has both advantages and disadvantages.

1.8.1 Standard Deviation:

The most common measure of volatility is standard deviation. To calculate


the standard deviation, we have to first determine a time frame for returns
we wish to measure. That is, we must determine whether we wish to measure
the volatility of hourly returns, monthly returns, etc. Standard deviation is a
measure of dispersion from the mean. The more is the deviation the more is
volatility and vice versa.

Where: S.D. = ∑ (r t − r t )2
n −1

r t = rate of return on the day

r= the average rate of return for the month

i= the day identifier for the month (i.e. for a month, I goes from 1 to 30 or 31)

The primary advantage with standard deviation is that everybody is familiar


with and understands it. It is easy to calculate, and is readily available from
a number of sources (e.g., spreadsheets, calculators, etc.). However, there
are a number of problems with this measure. As the time frame decreases,
the measure’s validity is less certain. One also needs to calculate the mean
return for the period analyzed. Further, we must specify a time frame for the
returns, and the relevant time period. Consequently, it is historical in nature.
Therefore, it homogenizes the information i.e. every piece of information
old or new is given equal weight.

34
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.

To fully comprehend the GARCH model introduced by Bollerslev (1986)


there should be a clear understanding of the underlying assumption and
models from which GARCH is derived. In its simplest form, an
autoregressive model is a model in which we use the statistical properties of
the past behavior of a variable y to predict its behavior in the future. An
overview of these models is given below:

Autoregressive Model:

An autoregressive model is a model in which you use the statistical


properties of the past behavior of a valuable to predict its behavior in future.
In other words, we can predict the value of the variable yt by looking at the
sum of the weighted values that yt-1 took in previous period plus an error
term given by et. An AR model with one lag of term is called as AR(1)
model. The AR(1) model is given by the following equation:
y t = b 0 + b 1 y t-1 +e t
where
b 0 is the constant
b 1 is the weight
y t-1 = value of y one period ago
e t = error term
an autoregressive model with weighted sum of pervious (p) lags of y is
called an AR(p) model (where p = 1,2………n)
1.8.3. Moving Average Model:
A simple linear combination of white noise processes that makes a variable
yt dependent on the current and previous values of a white noise disturbance
term can be given as:
y t = b 0 + b 1 e t-1 +e t

36
where

b 0 is the constant

b 1 is the weight

e t-1 = value of error one period ago

e t = error term

An MA model with weighted sum of previous (q) lags of y is referred to as


MA (q) model (where q = 1,2……..n)

ARMA Model:

By combining AR & MA models described above, we get a model or a tool


for predicting future values of a variable yt which is referred to as an
autoregressive moving average model, or ARMA (p,q). This model states
that the current value of sum series yt depends linearly on its own pervious
values (AR) plus a combination of current and pervious values of a white
noise error term (MA).

y t = b 0 + b 1 Y t-1 +α1 e t +e t

The ARMA (1.1) models is given by:

An ARMA model with (p) lags of yt and (q) lags of et will be called as
ARMA (p.q) model.

Exponentially Weighted Moving Average (EWMA) 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

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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.

A higher lambda indicates slower decay in the series. If we reduce the


lambda, we indicate higher decay: the weight fall off more quickly.

The ARCH Model:

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.

Time series data shows certain characteristics like heteroskedasticity (non


constant variance), volatility clustering, leptokurtosis and reversion towards
the mean. Linear models are not able to capture these characteristics of the
time series data.

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

e 2 t-1 = lagged squared error term

We can capture more of the dependence in the conditional variance by


increasing the number of lags, p, giving as an ARCH (p) model.

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.

The GARCH Model:

Empirically, the family of GARCH (Generalized ARCH) models has been


very successful in describing the financial data. ARCH and GARCH models
treat heteroskedasticity as a variance to be modeled. of these models, the
GARCH (1,1) is often considered by most investigators to be an excellent
model for estimating conditional volatility for a wide range of financial data
(Bollerslev, Ray and Kenneth, 1992).

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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.

The GARCH (1,1) model is given by:

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.

Motivation of the Study:

Generally, to type of arguments prevail in the existing literature one. Once


school of thought argues that derivatives trading increases stock market
volatility due to high degree of leverage, transaction costs and hence
increases speculation and destabilizes the market. On the other hand, another
school of thought claims that Financial Derivatives playa an important roll
in price discovery, enhances market efficiency and reduces asymmetry
information of spot market and has beneficial effect on the underlying cash
market. This gives risen to the controversy among the researchers,
academicians and investors on the effect of derivatives on the underlying
market volatility.

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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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