Relevance / need:

(general)

Derivatives Trading: Why in India?

In this section we shall see the general as well as the specific advantages, in Indian
context, of derivatives trading. Empirical evidence in their support will also be examined
in the end. The need for derivatives in Indian capital markets has been expressed for the
following reasons:

• Introduction of derivatives will result in better liquidity and efficiency in the Indian
equity markets.
• Better liquidity results from the tremendous leverage afforded by
derivatives since a trader needs to have a small fraction of money to take a
position as compared to what is required in the cash market where he/she
actually buys the asset.

• The improvement in efficiency results from two sources. First, the price
discovery function performed by the derivatives that enhances the
informational efficiency of the market. The prices of derivatives change more
quickly to reflect the latest information where as the price of the underlying
asset responds with a lag. This price discovery role is played mostly by the
futures ( on the stock index or individual securities).

• Second, the allocative efficiency of the market is increased because the

resources are directed to the sectors, which offer best rates of return given a
risk level. This allocative efficiency is a direct result of the better information
flow and the ability to hedge risk due to derivatives.

• Just as futures discover the price of underlying assets, options reveal the
market’s perception of the volatility of the price of the underlying asset. Thus,
the market’s perception of future volatility can be gauged by the implied
volatility implicit in the options pricing. High volatility projections by the
market can effect the decisions on portfolio management, investment
decisions etc.

• Some derivatives, especially the stock index futures / options protect investors from
the markets risk arising out of uncertainty in the movement in the stock index. These
instruments provide a way for diversification to the market participants without
having to buy a whole lot of securities. Although, stock index futures are a zero sum
game when seen in the context of overall economy, they allow the transfer of risk
from those who wish to avoid risk to those who wish to take on the risk. This makes
the investments in equities less risky.
• If derivatives are not traded, both the speculative and non-speculative orders are
carried out in the cash market. But after introduction of derivatives there is a splitting
of roles between the derivatives and cash markets. The cash market caters to the non-
speculative orders whereas derivatives market serves the needs of more speculative
traders because of high liquidity and leverage provided by derivative market. Hence,
whenever there is a news, the derivatives prices respond instantaneously and later the
cash prices change through arbitrage.

• Trading in derivatives will make Indian equity markets more attractive for the foreign
investors since derivatives will serve as hedging vehicles. Foreign investors are
exposed to two broad categories of risk: the currency risk and the country risk. The
currency risk will be taken care of by the currency forwards, futures, options and
swaps whereas the country risk can be minimised using the index futures and options.

• In the absence of derivatives on the stock indices, the speculators are forced to take
positions on individual securities in order to implement their views about the index.
In addition to increasing the volatility of the cash market of individual stocks, this
action is highly inefficient because of the high transaction costs.

• It is also argued that derivatives trading is the next logical step in development of
Indian equity markets and that Indian market has been prepared for derivatives
trading by the structural changes introduced in last 6-7 years. Also, the skills
developed in the will lend themselves for applications in other areas such as
development of innovative contracts even in the commodity markets.( Although
commodity derivatives have been introduced earlier, the financial derivatives attract
real attention and outstanding talent to this field.) Derivatives trading will also allow
many economic agents to sell innovative insurance products to others.

Empirical evidence in support of the advantages outlined above:

• Danthine (1978, as cited by Bessemsinder and Seguin ,1992) shows that the existence
of futures markets improve market depth and reduces volatility, because the cost to
informed traders, of responding to mispricing, is reduced.

• Another major role of stock index futures is their price discovery function. Many
analysts believe that the difference between the futures price and the index can be
used as an indicator of forthcoming moves in the index and thus an extraordinarily
large basis (positive or negative) would tend to an indicator of an impending bullish
or bearish move (Kawaller, Koch and Koch, 1987). Kawaller et. al, 1987, empirically
investigate the intraday price relationship between the S&P 500 index and S&P 500
index futures to determine the existence and nature of information contained in each
price, regarding subsequent movements in the other price. They find that the S&P
500 index and futures prices are simultaneously related on a minute to minute basis
throughout the trading day, that the lead from futures to cash prices extends for
between twenty and forty-five minutes and the lead from cash to futures prices rarely
 extend beyond one minute. But they also suggest that any implications of
forthcoming price movements implied by the lag structure are unlikely to be
exploitable for profit since the price adjustments due to independent causal forces can
be expected to be substantially higher.

• In a similar study, Stoll and Whaley, 1990, investigate the time series properties of
intraday returns of stock index and stock index futures contracts. They find that S&P
500 and MMI futures returns lead stock index returns by about five minutes, S&P 500
and MMI futures returns also lead even the returns on the actively traded stocks like
IBM, and although futures returns tend to lead stock index returns, the effect is not
completely unidirectional. According to them, the phenomenon of futures market
leading the stock market is attributable in part to the fact that not all stocks in the
index trade continuously. The remaining predictive power of futures can be taken as
evidence supporting the price discovery hypothesis that new market information
disseminates in the futures market before the stock market.

• Pizzi, Economopoulos and O’Neill, 1998, try to distinguish between short-run

deviations from equilibrium indicative of price discovery and long-run deviations that
account for efficiency and stability. They find that the futures market leads the spot
market by at least 20 minutes whereas the spot market leads the futures by at least 3
minutes. Thus while the futures market tends to have a stronger lead effect,
unidirectional causation of futures-to-spot is ruled out.

Bessemsinder and Seguin, 1992, provide a theoretical explanation for the

improved market depth and efficiency of the cash market after introduction of derivatives
trading. According to them stock index futures allow traders to obtain market-wide risk
exposure with substantially lower transaction costs than if spot positions are taken, and to
establish a larger position (due to lower margin requirements) than would be possible in
the spot. In short, futures markets allow traders to generate larger order flows at lower
costs.

The above evidence suggests that great economic benefits can indeed be derived
from derivatives trading. But if it were really so everybody would have welcomed
derivatives trading. Obviously, there are certain drawbacks of derivatives trading that are
the subject of the next section.

The disadvantages of derivatives trading:

Bessemsinder and Seguin, 1992, provide evidence on whether greater futures

trading activity is associated with greater equity volatility by including futures trading
activity (volume and open interest) along with spot trading activity in the analysis. They
find a positive correlation between equity volatility and contemporaneous trading
volumes in the spot equity and stock index futures markets. They also show that
unexpected futures trading volume is positively associated with spot volatility, but the
relation between expected futures trading volume and spot volatility is found to be
negative. They also find evidence that equity volatility declines as a function of open
interest in the stock index futures markets.
Antoniou, Holmes and Priestley, 1998, report that the onset of futures trading has
had a limited impact on the level of stock market volatility but it has had a major effect
on the dynamics of the stock market. They find that there has been a transference of
‘asymmetric response to news’ from the spot market to the futures market. Also, contrary
to traditional view of futures trading, they find an improvement in the way that news is
transmitted into prices following the onset of futures trading.