The Relationship Between Price Volatility, Trading Volume and Market Depth: Evidence from an Emerging Indian Stock Index Futures Market

This paper examines the relationship between futures trading activity and price volatility in the Indian stock index futures market. The study used both volume and open interest to separate hedger’s trading activity from speculators and day traders. Volume gives a measure of speculative activities whereas open interest is a measure of hedging positions. The data consists of daily closing price, volume and open interest of Nifty index futures from the period January 1, 2001 to June 28, 2007. The study investigates whether the effect of trading activity on volatility is homogeneous by separating volume and open interest into its expected and unexpected components and allowing each component to have a separable effect on observed price volatility by following appropriate ARMA-GARCH and ARMA-GJR-GARCH models. Futures price volatility is positively related to both the expected and unexpected components of volume. However, unexpected volume has a greater impact on volatility than expected volume. Volatility is negatively related to the expected level of open interest and the coefficient of unexpected component of open interest is statistically insignificant. A significant negative coefficient of expected open interest could be interpreted as: Higher expected level of open interest leads to lower futures price volatilities and a more stable futures market. This contributes to the literature on the microstructure of Indian futures markets by investigating the empirical relationship between trading volumes and volatility.