Does Futures Trading Effect Spot Price Volatility? A Study on NSE Nifty

The belief that trading activity in equity futures markets can lead to excess volatility in spot equity markets is widely held. The popular opinion is that equity index futures allow traders to obtain market-wide risk exposure with substantially lower transaction costs than if spot positions are taken. Trading on NIFTY futures was introduced on the 12th of July 2000. This study aims to study the impact of the introduction of stock index futures on the volatility of the Indian spot markets. The change in the volatility is compared not only in absolute levels of volatility but also in terms of the structure of the volatility, which was measured by Chow test. Weekly volatility series were constructed from daily spot closing prices for NSE Nifty index. The data set consisted of 558 weekly observations from April 1997 to April 2007. The study considered six different measures of volatility including the Figlewski (1981) volatility measure. A general dynamic linear regression model was constructed to explain spot volatility. The investigation utilized the GARCH family of statistical models like GARCH-M and I-GARCH model, to investigate volatility in NSE Nifty spot prices both before and after the onset of futures trading. The tests confirmed that there was no structural change after the introduction of futures trading. The GARCH analysis revealed that whilst the pre-futures sample was integrated the post-futures sample was stationary. This observation implies that the persistence of shocks has decreased since the onset the derivative trading. Further, it is evidenced that spot returns volatility is less important in explaining spot returns after the advent of futures trading in NSE Nifty index. Results from the regression analysis are consistent with the majority of previous studies in that they reveal no apparent change in volatility. In conclusion we find no evidence to suggest that there has been a spillover of volatility from the futures to the spots market in NSE Nifty index. Our results imply that futures markets serve their prescribed role of improving pricing efficiency and providing a hedging vehicle which lessens the importance of volatility.