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Research Proposal: D Phil Thesis

Research Topic: Derivatives Trading and Its Impact on the Volatility of The Johannesburg Stock Exchange

Jecheche Petros

University of Zimbabwe

1.0 INTRODUCTION Warren Buffett may have called derivatives 'weapons of mass destruction' but even he has a number of derivative positions in his Berkshire Hathaway portfolio. In short derivatives can be dangerous but they can also be excellent trading and hedging tools if used correctly and with full knowledge of how they work. Recent years have seen an explosion of derivative products on the Johannesburg Stock Exchange (JSE) with international stocks, currencies, commodities, interest rates, agricultural products, local stocks and indices available for trading. Larouche, a fierce critique of derivatives once said, The significance of the derivatives is the fact that they can be tolerated. The fact that they are tolerated in the way they are tolerated, in the way they are discussed in the financial community, indicates that no one in their right mind would invest in this planet, as long as the kind of thinking behind derivatives is hegemonic. Although derivatives have been criticized, this does not mean they are completely useless. Derivative trading failed in countries such as Pakistan because of poor management.Crane et al. (1995) argue for a functional perspective that takes as given the economic functions performed by financial institutions and then seeks to discover the best institutional structure for performing those functions at a given time and a given place. The Johannesburg Stock Exchange (JSE) being the only registered exchange that trades in financial instruments in South Africa has grown phenomenally over the past years as shown by the All Share Index (ALSI), the Industrials Index (IND) and the Gold Index (GOLD) indicating an increase in market volumes traded on the exchange. This however, has transpired on the backbone of recurrent bubbles which have hit the financial sector. With such an environment, financial organizations are being exposed to high portfolio management risks which are inhibiting growth and sophistication. The issue of the impact of derivatives trading on stock market volatility has received considerable attention in recent years the world over, particularly after the financial crisis. Derivative products like futures and options on the Johannesburg Stock Exchange have become important instruments of price discovery, portfolio diversification and risk hedging in recent times. Generally, volatility is considered as a measurement of risk in the stock market return and a lot of discussions have taken place about the nature of stock return volatility. Therefore, understanding factors that affect stock return volatility is an imperative task. This study examines the impact of trading in major derivatives products including index futures, stock futures and index options on the conditional volatility of stock market return and makes an effort to study whether the volatility on the JSE has undergone any significant change after the introduction of derivatives trading. 1.1 BACKGROUND TO THE STUDY In South Africa, the first derivatives exchange was founded in 1987, when local merchant bank, Rand Merchant Bank (RMB), created an informal market for derivatives. In 1990, the

Johannesburg Stock Exchange launched their Equity Derivatives Division, which oversees trading in warrants, single stock futures and options, equity index options and futures, as well as interest rate options and futures (Adelegan 2009). With the deregulation of the South African agricultural industry in 1995, agricultural commodity futures were introduced and the South African Futures Exchange (SAFEX) Agricultural Markets Division established. The first commodity futures listed were on beef and potatoes. Both underlying assets were delisted shortly after their introduction as demand was too low. The most popular underlying assets listed on the South African Futures Exchange are white and yellow maize, which were first listed in 1996. In subsequent years futures contracts on wheat (1997), sunflower (1999), soybeans (1999), oil (2009), platinum (2009), gold (2009) and sorghum (2010) were listed, and the first options on commodities were introduced in 1998 (Adelegan 2009; Bain 2009). 1.2 PROBLEM STATEMENT Financial organizations in South Africa have been exposed to high portfolio management risks over the past few years which are inhibiting growth and sophistication. This is despite the trading of derivatives on the JSE. However, no effort has been made to determine the extent to which the volatility of stock returns on the JSE has been affected by derivatives trading. This study examines the impact of trading in derivatives products on the conditional volatility of stock market return and makes an effort to examine whether the volatility on the JSE has undergone any significant change after the introduction of derivatives trading. 1.3 OBJECTIVES The study seeks to: assess the behaviour of volatility on the JSE after the introduction of derivatives contracts evaluate whether derivative trading affects the long term performance of stocks traded on the Johannesburg Stock Exchange examine with help of econometric model whether the introduction of derivative contracts has reduced the risk and inefficiency in the South African stock market or not. 1.4 RESEARCH QUESTIONS The paper therefore seeks to answer the following research questions: a) Has there been any change in volatility on the JSE after the introduction of derivative contracts? b) Does derivative trading affect the long term performance of stocks traded on the Johannesburg Stock Exchange? c) Did the introduction of derivatives reduce risk and inefficiency in the South African stock market or not? 1.5 HYPOTHESIS

One view is that derivatives trading increases volatility in the spot market due to more highly leveraged and speculative participants in the futures market. An alternative view is that derivatives trading reduce spot market volatility by providing low cost contingent strategies and enabling investors to minimize portfolio risk by transferring speculators from spot markets to futures markets. So, for all the models, the null hypothesis (H0) is that the introduction of the derivatives products has not reduced the volatility of spot market. The alternative hypothesis (H1) is that H0 has been rejected.

1.6 JUSTIFICATION AND MOTIVATION OF STUDY Derivative trading desks in Zimbabwe were closed in 2003 by the Reserve Bank of Zimbabwe. A study on the impact of derivative trading on the South African stock market will guide Zimbabwe on whether to reintroduce derivatives or not. If derivative trading has reduced volatility in South Africa, it may be worthwhile for Zimbabwe to reconsider derivatives and vice versa. 1.7 LITERATURE REVIEW 1.7.1. Uses of Derivatives Instruments There are four main uses of derivative instruments which are Hedging, Speculation, Arbitrage and Leverage (Chisholm, 2004). Chisholm outlined the importance of derivative instruments through their application in asset management firms. Hedging refers to the action taken to protect an existing market position or asset from an adverse market move for example a stock market crush that could erode the value of a portfolio. Speculation was defined by Hull (2001) as entering a contract with the express purpose of making a profit. An arbitrage is a deal that produces risk free profits by exploiting a mispricing in the market. Leverage enables a greater gain (loss) to be made for a given amount of initial capital employed-higher risk for higher returns. In this sense, derivatives can be used as an efficient avenue to obtain leverage in financial markets.

1.7.2. IMPORTANCE OF A DERIVATIVE MARKET The Deustche Bundesbank report (2006) states that an active derivatives exchange plays an important role in facilitating an efficient determination of prices in the underlying cash (or spot) market by providing improved and transparent information on both current and future prices for an asset. Derivatives can also be used to generate and deliver abnormal performance that can be packaged within a core-satellite approach to portfolio management, that option portfolios can be used to enhance the performance of tactical asset allocation programmes and that fixed-income derivatives offer significant risk reduction benefits in an asset-liability management context (Gibson, 1991). Derivative markets also contribute to the integration of global capital markets, hence improving the global allocation of savings and fostering higher investment levels (Chisholm, 2004).

1.8 RESEARCH METHODOLOGY 1.8.1 DATA The study will use secondary data sources. Therefore, there will be no need for the researcher to travel to Johannesburg since data is readily available. The analysis is based on daily time series data. Data for the All Share Index (ALSI) will be used. This data will be obtained from the I-Net database. (The I-Net database is maintained by the firm of Ivor, Jones, Roy and Company, a firm of stockbrokers in Johannesburg, which has recently been taken over by Deutsche Morgan Grenfell.) The closing prices in the end of the day will be used. The whole time period will be divided into two sub-time periods. First is pre-derivatives introduction period and the second sub-time period is post-derivatives period from 1987 to 2010.

The Autoregressive Conditional Heteroskedasticity (ARCH) and Generalized ARCH (GARCH) models will be employed to estimate the conditional volatility of stock market returns and the impact of the derivatives trading. GARCH model will be used to test the informational effect on the conditional volatility of stock market return. Stock market return will be calculated from the daily closing prices of the All Share Index (ALSI). This is one of the most important and popular indicators of the JSE. This Index is a good predictor of the stock market volatility. Dummy variables for these derivatives products (index futures, stock futures and index options) are used as independent variables. Both the futures and options are actively traded on the Johannesburg Stock Exchange (JSE). The series have been created using 0 for pre-derivatives introduction period and 1 for post-derivatives introduction period to get a time series as usual used by the experts. If the coefficient on the dummy variable is statistically significant, the introduction of derivatives has a significant impact on the spot market volatility. 1.8.2 THE GARCH MODEL A model with errors that follow a GARCH (1,1) process is represented as follows: Yt ht Where, ht Ut = = conditional variance (sigma square) Error term = = a + b1Xt + Ut a + b1(Ut-1)2 + b2ht-1 1 2

Equation '1' is called the conditional mean equation and equation '2' is called the conditional variance equation. The coefficient of the error square term can be viewed as a news coefficient, with a higher value implying that recent news has a greater impact on price changes. It can be predicted as the impact of yesterdays (the previous time period) news on todays (present time period) price changes. The coefficient of the variance (ht-1) reflects the impact of

old news in other words it is picking up the impact of prior news on yesterdays variance and as such indicated the level of persistence in the information effect on volatility. 1.9 LIMITATIONS OF STUDY The study will only focus on the All Share Index (ALSI). Due to the unavailability of data, the Industrials Index (IND) and the Gold Index (GOLD) will not be considered for the purpose of this study. 1.10 TIME FRAME The study will be conducted over a period of four years (2012 2016). This is illustrated on the following table:

Chapter 1 2 2 3 4 4 5 6 7

Description Introduction Background of Study Statement of Problem and Objectives Literature Review Research Methodology Data collection Data Analysis Conclusion Recommendations

Time frame 3 Months 6 Months 3 Months 6 Months 6 Months 6 Months 12 Months 3 Months 3 Months

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