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Weekly UpdatesINTRODUCTION
There is a debate in the literature as to whether stock market development adds to economic growth. (1) Levine (1991) and Bencivenga et al. (1995, 1996) argue that stock market development, which reduces the liquidity risk of investors, encourages investment in long-term projects that is an important pre-condition for economic growth. Indeed, in order for financial resources to be efficiently allocated, credit markets may have to be necessarily supplemented by well-functioning equity markets (see Cho, 1986). Others have argued that the greater liquidity of the asset traded in stock markets, that is, equity, would reduce the incentive of the investors to screen and monitor the companies that raise capital in the stock markets, thereby adversely affecting the productivity of these companies (Shleifer and Vishny, 1986; Bhide, 1993). Yet others have argued that stock markets are not the primary source of capital for most firms (Mayer, 1988), and that they might actually become the vehicle for wasteful use of capital by way of activities like mergers and acquisitions (Shleifer and Summers, 1988; Morck et al., 1990a, b). Recent empirical work, however, tends to be more consistent with the argument that stock market development has a positive impact on economic growth (Levine and Zevros, 1998, 2002).
Development of stock markets typically involves a number of policy initiatives, and most of these focus on increasing the liquidity of the secondary markets. The reduction in risk associated with an increase in the liquidity of secondary markets is expected to facilitate greater investment through equity in the primary market. In part, enhancement of liquidity in the secondary market, which is contingent on the participation of a large pool of investors in the transactions, depends on development of rules/ norms and infrastructure like accurate disclosure of companies' financial performance and rapid settlement processes, respectively, that substantially reduce informational risk, counterparty risk and the risk of fraud. It is also argued that liquidity in the secondary market is enhanced by introduction of trading practices like short selling that allow investors to take positions in the market without being restricted by the size and contents of their portfolios. Finally, liquidity is expected to increase in the aftermath of the introduction of equity derivatives that allow investors to hedge their positions against market risk.
It is of little surprise therefore that there has been a significant increase in trading in equity derivatives since the early 1980s. According to the figures released by the World Federation of Exchanges (WFE) in December 2004, the average of the ratio of equity derivatives notional value turnover to cash turnover in the 25 largest stock exchanges of the world stood at 1.55. More recent figures released by WFE suggest that the growth of equity derivatives trading continues unabated. For example, between 2006 and 2007, there was a 98% increase in the worldwide traded volume of stock futures, the measure of volume being the number of contracts traded. The growth rate of volume of stock index futures for the same 1-year period was 32%.
However, the growth in derivatives trading is not viewed as an unequivocally desirable attribute of equity markets. Indeed, even though the 1987 stock market crash in the United States was not attributed to futures and options trading per se, there was some concern among regulators that programme trading and index arbitrage that link the derivatives and cash markets to each other may have exacerbated the crisis (Edwards and Ma, 1992, Chapter 11). By its very nature, arbitrage between the cash and (especially) futures markets require investors to unwind positions in the latter market on the day of expiration of contracts, in order to realise arbitrage profits. The consequent increase in the number of large buy and sell orders, and the temporary mismatch between these orders, can significantly affect prices and volatility in the underlying cash market. Not surprisingly, regulators around the world have responded with a number of measures aimed at reducing price volatility on account of the so-called expiration effect of equity derivatives.
The importance of expiration day effects on the cash market to regulators has, in turn, generated interest on such effects within the research community. As a consequence, the impact of expiration of futures and options contracts on the underlying cash market has been examined in a number of contexts (see, eg, Chamberlin et al., 1989; Pope and Yadav, 1992; Stoll and Whaley, 1987, 1991, 1997; Bollen and Whaley, 1999; Alkeback and Hagelin, 2004). While the nature of the impact of expiration of derivatives on underlying cash prices remains an open question, some researchers have found evidence of significant positive impact of expiration of equity derivatives on stock market volatility (see Chow et al., 2003). This itself can be a cause for worry, given that volatility is viewed as being detrimental to the growth of stock markets (Pagano, 1993; Singh, 1997). The problem can be particularly acute if the increase in volatility on account of expiration of derivatives contracts is so large as to trigger a Black Monday type catastrophe in fragile stock markets in developing countries or emerging markets.
In this paper, building on Vipul (2005), we examine the expiration day effects of equity index derivatives at the National Stock Exchange (NSE) in India, the second fastest growing (emerging) economy in the world. The Indian stock market has grown rapidly since its liberalisation in the early 1990s. Since its inception in 1994, the market capitalisation at the NSE has grown by 828%; growth since the turn of the century has been 412%. The growth in the derivatives segment of the exchange, which was introduced in June 2000, has kept pace with the growth in the cash market. Between April 2002 and March 2006, the total turnover of the derivatives segment increased by 4,633 %, while the average daily turnover increased by 4,587 %. At the end of November 2006, 1,098 companies were listed on the exchange, and 1,014 of these stocks were regularly traded. The meteoric growth of the cash and derivatives segments of the NSE is graphically highlighted in Figures 1-3. Of the 1,098 listed securities, 123 act as underlying assets for futures and options contracts. In addition, three indices are used as the underlying assets for futures and options trading at the exchange. Details about the nature of these equity derivative contracts are reported in Table 1. In November 2006, the turnover in the derivatives segment of the equity market was 342 % of the corresponding turnover in the underlying cash market. Most importantly, the Indian stock market experiences the 'quadruple witching hour'. On the last Thursday of every month, index futures and options as well as futures and options contracts on individual securities expire.
[FIGURE 1 OMITTED]
We examine the expiration effects of derivatives on the market index as opposed to prices of individual stocks because this allows us to mitigate problems that might arise on account of information that affect prices of individual stocks much more than a broader market index. Also, broad market indices are much less likely to be affected by liquidity effects than prices of individual stocks. Further, as evident from Figure 3, the turnover in the index derivatives markets is much greater than that in the market for derivatives products associated with individual stocks, and therefore expiration day effects is likely to be much more prominent for market indices than for individual stocks. Second, we examine the impact of the expiration of derivatives contracts on intra-day volatility, using a number of measures of such volatility. Finally, we jointly model the impact of the expiration of these contracts on the returns to the market index and the volatility of these returns, using generalised autoregressive conditional heteroskedasticity (GARCH) models. (2)
[FIGURE 2 OMITTED]
Our results indicate that NSE expiration of index-based derivatives contracts have a significant impact on the trading volumes in the cash market; the volume of trading is higher on expiration days than on nonexpiration days. However, there is no statistically significant (or meaningful) difference in the respective mean returns and intra-day volatility of the market index. Further, the volatility of inter-day returns is actually lower on expiration days, relative to non-expiration days. Finally, these results are robust to the participation of foreign institutional investors (FIIs) in equity derivatives trading, and hence to the inflow of foreign funds into derivatives segment of the stock market. In other words, the introduction of trading in equity derivatives has not increased volatility at the largest Indian stock market.
[FIGURE 3 OMITTED]
The rest of the paper is as follows: In the next section, we describe the data, and perform some basic tests for expiration day effects. In the subsequent section, we discuss the GARCH models and the associated coefficient estimates. The last section concludes.
DATA AND INITIAL RESULTS
For our analysis, we use daily data for the market index for NSE--the 'Nifty'--for the June 2000 through September 2006 period. The Nifty is a 50-stock market capitalisation weighted index whose component companies cover 22 different industries. Currently, the stocks included in the Nifty account for about 60% of market capitalisation of all NSE listed companies. Overall, we have data for 1,594 trading days, of which 76 were days on which derivatives contracts expired at the exchange. We repeat all empirical exercises using a subset of this data, namely, for the February 2002 through September 2006 period. The significance of this sub-period is that FIIs were allowed access to the derivatives segment of the exchange from February 2002. Given that purchase and sell orders of FIIs currently account for 15 % of the turnover in the cash market, and reportedly a significant proportion of the turnover in the derivatives market, this distinction is clearly important. The sub-sample accounts for 1,175 trading days, of which 56 days witnessed the quadruple witching hour.
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