The Maturity Structure of Volatility and Trading Activity in the KOSPI200 Futures Market

Abstract

ABSTRACTThis study examines the effects of trading activities on the maturity structure of the volatility in the KOSPI200 futures market. It involves estimation of a variant of the E-GARCH(1,1) model of futures returns. The empirical results suggest that the KOSPI200 futures market tends to be volatile right before and right after the nearest contract expires.High volatility immediately prior to maturity can be explained within the framework of the well-known Samuelson hypothesis. However, it is not easy to explain why volatility increases right after the nearest contract expires. To do so, we estimate the volatility equation by using expected and unexpected trading volume relative to open interest as explanatory variables. The results show that the observed U-shaped maturity volatility structure reflects the trading activity right before and right after the expiry, and, to be noteworthy, in particular, is that volatility increases immediately after the nearest contract reaches maturity, due to the high unexpected trading volume relative to open interest.The trading activity in the KOSPI200 futures market is typically heavily concentrated on the nearest contract, which is indicative of low levels of market depth in the next-to-nearest contract. This, in turn, suggests that there has been a temporary market thinness right before and after the replacement of the nearest contract. The KOSPI200 futures returns display a U-shaped maturity structure of volatility, due mainly to the temporary market thinness at the time of the expiry.Keywords: Samuelson hypothesis, maturity structure of volatility, trading volume, open interest, E-GARCHJEL Classification code: G13, C50(ProQuest: ... denotes formulae omitted.)INTRODUCTIONSince the introduction of the KOSPI200 futures contract in May 1996, the KOSPI200 futures market has seen enormous growth, with 4.7 billion contracts traded in 2006 alone, and it has become the fifth largest in the world.s stock index futures markets. As such, its impressive growth has drawn much attention over the past several years. We hereby examine the effects of trading activities on the maturity structure of the volatility in the KOSPI200 futures market.In his seminal article, Samuelson (1967) formulated a model where the volatility of futures returns tends to increase as the contract approaches maturity. As a result, returns of futures contracts close to expiration react more strongly to new information about the underlying asset than returns of more distant futures contracts. This is known as the Samuelson effect that is just a price elasticity effect. What follows are alternative approaches to tackling limitations inherent to the Samuelson hypothesis. To begin with, the state variable hypothesis proposed by Richard and Sundaresan (1981), and by Anderson and Danthine (1983) argues that heterogeneous information flows lead to violations of the Samuelson effect. In addition, the speculative hypothesis argues against the Samuelson effect, basing itself on the asymmetric information of traders, and on the assumption of homogeneous information flow.Much empirical research has been conducted into volatility in the futures markets, but it remains controversial whether the time-to-maturity pattern of volatility is monotonic or not [Castello and Francis(1982), Galloway and Kolb(1996), Keynon et.al(1987), and Khoury and Yourougou(1993)]. In this study, the maturity structure of volatility in the KOSPI 200 futures market is analyzed. Interestingly enough, it turns out that the volatility of the KOSPI200 futures returns follows a U-shaped curve as a function of days to expiry.1 The focus of this paper, in short, is how the trading activity in the KOSPI200 futures market interacts to produce a U-shaped time-to-maturity volatility pattern.It is well known that trading activity has effects on market volatility [Kyle(1985), and Bessembinder and Seguin(1993)]. …