Financial derivatives introduction and stock return volatility in an emerging market without clearinghouse: The Mexican experience

Abstract

This paper introduces an alternative methodology to test whether financial derivative introduction affects underlying stock return variance. Previous tests did not address the problem that variance changes systematically through time for individual firms as their leverage, investment opportunities, and other characteristics change. Our test consists in utilizing the Generalized Autoregressive Conditional Heteroskedastic (GARCH) process to generate time-series measure of stock return volatility, we then use these series to determine whether stock return variances change permanently when a financial derivative is introduced. We apply this alternative methodology to the Mexican case. Empirical results suggest that derivatives introduction does not reduce Mexican stock return volatilities; this result holds even before the well-known Mexican financial crisis of 1994.