Significance of Non-Price Variables in Price Discovery: An Empirical Study of Stock Option Market in India

Abstract

The efficiency of the financial markets is important as it ensures increased productive efficiency and economic growth through better capital allocation. Price discovery is the central aspect of financial markets. The relatively efficient price signals also facilitate the participation of uninformed investors to make suitable portfolio choices. Derivative instruments like option contracts enhance informational efficiency of the underlying's market through better price discovery as these securities are expected to increase the flow of information in the market. Besides, they facilitate hedging of risk. In India, exchange-trade derivates are of recent origin in the stock market. This study investigates the significance of net open interest and trading volume in stock option and stock index option market to predict the underlying stock prices⁄index level. In the study, only 15 stock option contracts (having maturity of one-month) and Nifty options for the entire period, i.e., November 10, 2001 to November 2, 2004, have been analysed. The analysis could not be carried out for all the stocks in option segment because of the fact that the options were not traded or the trading range and volumes were too thin to justify any analysis. The major findings of the study are as follows: Net open interest of stock option is one of the significant variables in the determination of the future spot price of the underlying stock. Open interest-based predictors are statistically more significant than the volume-based predictors in the Indian context too as is the case for the US market. The trading behaviour of Indian investors is found to be different from their counterparts in the developed world. This difference can be attributed to: the nascent state of derivatives market in India extremely limited participation of institutional investors in the Indian stock derivative market because of regulatory restrictions; as such investors are allowed to use derivative securities mainly for hedging and arbitrage purposes only. The findings would definitely help the regulatory bodies in policy-making and further strengthening the efforts to promote the derivative market in India. There are many areas which are still unexplored and can be addressed by the future studies by using the intraday data and a larger sample for the stock options.