Impact of Introducing Different Financial Derivative Instruments in India on Its Stock Market Volatility

Abstract

The impact of the introduction of derivative trading in the forms of stock index futures, stock index options, currency futures and interest rate futures in India over time on the underlying stock market volatility is examined here using data on daily closing prices of S&P CNX Nifty in a Generalized Autoregressive Conditional Heteroscedastic (GARCH) (1, 1) framework, capturing heteroscedasticity in stock market return. Our estimation period spans from 1 April 1996 to 31 March 2012. The results suggest that there is time-varying persistence of the stock market volatility throughout the estimation period. Further, the introduction of equity derivatives in the forms of stock index futures and stock index options and interest rate futures in the currency derivative segment have found to be successful in reducing the stock market volatility in India, whereas introduction of currency futures is observed to have a destabilizing impact on the stock market volatility of the country. The probable reasons behind these findings of the study are as follows: Derivative instruments are introduced on the general expectation of controlling risk, hence the volatility in the underlying spot market, which happened in the cases of equity derivatives. Same occurred in case of interest rate derivative because this instrument is expected to bring stabilization in interest rates, hence stock prices. But the ineffectiveness of currency futures in stabilizing the stock prices might happen due to excessive involvement of speculators in the foreign exchange market and current integration of the Indian economy with the rest of the world.