The Dynamics of Stock Index Futures and Spot Markets

A Survey of Literature

CopyLeft (2012): A. Chandra

Overview
The price-volume relationship in the stock market has always been an attraction for scholars and

practitioners.
Different measures of traders positions are related with themselves as well as with price volatility in

the underlying spot market.

A survey of recent research on the relationship between activities in the futures markets and volatility in spot market is presented.
CopyLeft (2012): A. Chandra

Research Objectives
To analyze the interaction among the measures of traders position in the context of stock index futures,
The causal relations among arbitrage, hedging, and
speculation activities in index futures market.

To

study

the

dynamic

relationships

between

measurement variables of traders position and spot

volatility, To examine the direction and magnitude of impact of traders position on spot market volatility.
CopyLeft (2012): A. Chandra

Related Literature
Ferris et al. (2002), AppEconLett, 9:
Dynamic interactions and causal relations between arbitrage opportunities (caused by pricing error) and a set of

endogenous variables, namely Implied Volatility, OI, &

Trading Volume; Negative correlation b/w volatility and pricing error

(consistent with Chen et al., 1995);

No evidence of direct relation b/w the level of OI and

volatility; Pricing error plays a critical role in linking implied volatility and the level of OI; OI should serve as a useful proxy for the flow of capital into or out of the market for stock futures.
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Related Literature cont

Tornell & Yuan (2009), WP:
Examine the relationship between the futures trading activities of speculators and hedgers and the potential movements of 4 major spot exchange rates (, , , & MXN$). Uses CFTCs COT data of futures positions decomposed by type of traders, large speculators, large hedgers, & small traders; Builds a Sentiment Index based on net position of respective type of traders (similar to Wang, 2001); Net positions and all exchange rates move together in a reliable & stable fashion; Speculators net positions vely covary with future spot currency movements (similar to Klitgaar & Weir, 2004); No pervasive evidence of sentiment index predictability for future spot prices in currency markets; Analyzing peaks & troughs show that speculators peak & hedgers trough positions have significant +ve connections with future spot rate changes, while speculators troughs & hedgers peak behave otherwise; Introducing peak/trough indicator variables in the model increases the forecasting power of the level of net positions.
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Related Literature cont

Yen et al. (2010), JoEco&Fin, 34:
Examine interrelationships amongst volatility, TVOL & TOI in Taiwan stock exchange futures market and the role of TVOL & TOI in dynamic setting of GARCH modeling and forecasting; Significant in-sample relationships amongst, daily volatilities, lagged TVOL, & lagged TOI; No significant evidence of out-of-sample forecastability of TVOL & TOI for volatility; Findings support theories of sequential info. arrival & traders with trade time-discretion tend to trade when market is relatively liquid.
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Related Literature cont

Pati (2008), SAJM, 15(2):
Examines the relationship b/w trading activity and price volatility in NSE Index futures market; Assumes trading volume as a measure of speculative activities, and OI as a measure of hedging positions; Uses ARMA-GARCH and ARMA-GJR-GARCH framework;

Futures price volatility is positively related to both expected

and unexpected components of trading volume, unexpected volume exerting more impact on volatility; Volatility negatively related to the level of OI, implying higher expected level of OI may lead to lower futures price volatilities and more stable futures market.
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Related Literature cont..

Kumar & Pandey (2011), WP:
Examine price volatility, trading volume and OI in Indian commodity futures market; Three measures of volatility used, daily vol. (Close-Close), non-trading vol. (Close-Open), & trading vol. (Open-Close); Trivariate VAR based G-causality model along with variance

decomposition and IRF used;

Volume parameters significant, yet volatility is mainly explained through its own lagged values; Insignificant relationship b/w volatility and the level of OI; Asymmetric relation b/w trading volume and OI (lagged OI affects volume +vely, but lagged volume affects OI vely).
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Related Literature cont

Gahlot & Datta (2011), JoTM, 16(1):
Studies the impact of futures trading on efficiency and

volatility of the Indian stock market;

Data used on CNX100, CNX500, & MSCI ACWI Index for Apr.2005 Mar2010; Futures trading has no significant effect on stock market volatility; EGARCH results show that CNX100 returns vely related to its own values, while +vely related to CNX500;

Introduction of futures trading causes market become

inefficient.
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Related Literature cont

Pati & Rajib (2011), AppEconLett, 18:
Uses 5-min intra-day prices to study the relationship b/w Nifty futures and its underlying spot index in terms of both returns and volatility; Combination of methodologies incl. J-J Cointegration, VECM, G-causality & bivariate GARCH(1,1) applied on highfrequency returns and volatility data; Although both series of futures and spot prices move together, there exists unidirectional causality from futures to spot market; Cointegration results suggest that both markets may be in disequilibrium during short-term, such deviations are quickly corrected during arbitrage process.
COPYLEFT (2012): A. CHANDRA

Related Literature cont

Both arbitrage and speculation play a role in determining (oil) futures prices, arbitrage being more dominant [Moosa & AlLoughani, 1995]. Introduction of stock index futures increases the volatility of stock market in short-term which further disrupts stability of the market [Fang & Chen, 2011; Gahlot & Datta, 2011]
Counter-evidence by Lean et al. (2010) & Wats (2011) supporting the role of futures trading in reducing the underlying spot market volatility and enhancing market efficiency.

No unanimous findings on the role of various measures of trading volume & OI in affecting volatility.
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Summary
Alternative measures of price volatility (Kumar & Pandey, 2010) might be related to trading volume measures differently;

In absence of any structured dataset on speculators and

hedgers, trading volume and OI appears good enough, but additional parameter similar to sentiment index (Tornell 7 Yuan, 2009) is expected to better explain the relationships; The magnitude of impact of traders positions has largely been unexplored, both in global and Indian context; The direction of relationships between futures and spot markets remain an issue of further investigation and debate given the lack of unanimous empirical evidence.
CopyLeft (2012): A. Chandra