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Copyright: Reserve Bank of India 2011
AN EMPIRICAL ANALYSIS OF THE
RELATIONSHIP BETWEEN CURRENCY
FUTURES AND EXCHANGE RATES VOLATILITY IN INDIA
Somnath Sharma
1
Abstract
India moved away from pegged exchange rate to the Liberalized Exchange Rate
Management System (LERMS) in !!" and the mar#et determined exchange rate
regime in !!$ which is considered as an important str%ct%ral change in the exchange
rate mar#et& 'ith increased volatility in exchange rate and to mitigate the ris# arising o%t
of excess volatility( c%rrency f%t%res were introd%ced in India in "))* which is
considered as second important str%ct%ral change& It is believed that the c%rrency
f%t%res will help in hedging the expos%res of exchange rate to %nfavorable movements
in exchange rate& +he role of derivatives for ris# ta#ing and ris# management cannot be
%nderstated by any means and it has increased significantly in recent times& +his paper
foc%ses at the relation between volatility in the exchange rate in the spot mar#et and
trading activity in the c%rrency f%t%res& +he res%lts show that there is a two,way
ca%sality between the volatility in the spot exchange rate and the trading activity in the
c%rrency f%t%res mar#et&
JEL Classification Code: F31, F39
Keywords: Currency futures, exchane rate !olatility, tradin
INTRODUCTION
1
"o#nath "har#a is a $esearch %fficer in the &e'art#ent of Econo#ic and (olicy
$esearch )&E($*, $eser!e +an, of -ndia. /he author is rateful to "#t. $e,ha 0ishra,
&irector, &E($ and anony#ous referees for their !aluable suestions towards the
successful co#'letion of this 'a'er. /he !iews ex'ressed here are strictly those of the
author and not of $+-. Co##ents #ay be forwarded to the author .
&urin the early 1991s, -ndia e#bar,ed on a series of structural refor#s in the
forein exchane #ar,et. /he #o!e#ent away fro# 'eed exchane rate rei#e to
'artially floated in 1992 and fully floated in 1993 was instru#ental in de!elo'in a
#ar,et3deter#ined exchane rate of the ru'ee and was a sinificant ste' in the
'roress towards total current account con!ertibility.
-n order to ad!ance -ndian forein exchane #ar,et to international standards, a
well de!elo'ed forein exchane deri!ati!e #ar,et was essential which started in 2114.
/he exchane rate 'olicy does not ai# at a fixed taret or a 're3announced taret or a
band but is su''orted by the ability of $eser!e +an, to inter!ene in the #ar,ets, if and
when necessary, only to s#oothen any undue !olatilities or disorderly #ar,et
beha!iour, while allowin the underlyin de#and and su''ly conditions to deter#ine the
exchane rate #o!e#ents o!er a 'eriod in an orderly #anner.
Currency futures tradin in -5$36"7 started on Auust 29, 2114. /ill January
2111, exchane rate futures was a!ailable only for 6" 7 !is383!is -ndian $u'ee.
Exchane3traded currency futures ha!e now been ex'anded to the euro, 'ound and
yen 'airin. At the ti#e of introduction of currency futures in -ndia, it was thouht that
the currency futures #ar,et in -ndia would #a,e a notable contribution towards
i#'ro!in the #enu of o'tions a!ailable for currency ris, #anae#ent. -nternational
ex'erience of the e#erin #ar,ets with the introduction of currency futures is a #ixed
one. -n se!eral cases, the !olatility is found to be reduced followin the constitution of
currency futures #ar,et, thouh e#'irical e!idence to the contrary also exists. /he
transaction !olu#es in currency futures in these countries ha!e re#ained too s#all to
'ut any sinificant u'ward 'ressure on exchane rate !olatility. Also, there is no clear
e!idence to 'ro!e that futures contracts traded on exchanes result in increased
!olatility in the 'rices for the underlyin co##odity. -n the liht of the abo!e, it will be
interestin to obser!e and analy9e the effect of introduction of currency futures on s'ot
#ar,et for exchane rate. /his 'a'er loo,s into this as'ect and atte#'ts to find out
whether introduction of currency futures and currency future tradin acti!ity has
increased due to the !olatility in s'ot #ar,et or not. (a'er will also try to find out if there
is any causality between exchane rate and futures tradin. /he 'a'er is di!ided into
three sections "ection - of this 'a'er discusses in brief the rele!ant literature. "ection --
discusses the &eri!ati!es #ar,ets in -ndia and the rationale for introduction of currency
futures in -ndia. "ection --- discusses the #ethodoloy and conclusions.
S!t"on I
1# L"trat$r R%"&
&es'ite the 'o'ular o'inion that increased !olatility in nu#erous financial
#ar,ets was enhanced by tradin in deri!ati!es, the e#'irical e!idence reardin this
issue is far fro# conclusi!e. "o#e studies 'ro!ide e#'irical results that su''ort the
o'inion that tradin in futures can destabili9e the s'ot #ar,et. For exa#'le, Filews,i
)1941* in!estiates the futures contracts for /reasury +ills ):50A 'ass3throuh
certificates* and 'ro!ides e!idence that futures #ar,et acti!ity increases the !olatility of
cash 'rices. 0ore recent study by +ae, Kwon and (ar, )211;* focuses on the effect of
the introduction of index futures tradin in the Korean #ar,ets on s'ot 'rice !olatility.
/he authors concluded that introducin the futures and o'tions tradin on the Korean
stoc, exchane resulted in both larer s'ot 'rice !olatility and reater #ar,et efficiency
)allowin for <uic,er ad=ust#ent of #ar,et 'rices to infor#ation*. "till, #any other
studies find so#e e!idence for the stabili9in effect of futures tradin on the s'ot #ar,et
or no e!idence for any casual relationshi' between futures tradin and the cash #ar,et
!olatility. &arrat, $ah#an and >hon )2112* find that index futures tradin cannot be
bla#ed for increased !olatility in the s'ot #ar,et. %n the contrary, their e#'irical results
suest that the !olatility in the futures #ar,et is itself an outrowth of a turbulent s'ot
#ar,et. A study by +esse#binder and "euin )1992* exa#ines whether reater "?(
@11 futures3tradin acti!ity is associated with reater e<uity !olatility. /heir e!idence
indicates that e<uity !olatility is 'ositi!ely related to s'ot3tradin acti!ity and to
conte#'oraneous futures3tradin shoc,s. 0oreo!er, they arue that e<uity !olatility is
actually #itiated when the bac,round futures acti!ity is hih. /hese findins contrast
sinificantly with other e#'irical studies that suest 'ositi!e relation between futures
tradin and s'ot #ar,et !ariability. :ulen and 0ayhew )2111* 'ro!ide #ixed e!idence in
their study on 2@ countries. /heir results indicate that after the listin of stoc, index
futures, s'ot !olatility #ay ha!e increased in the larest two #ar,ets, the 6nited "tates
and Ja'an, while it decreased or stayed rouhly the sa#e in the re#ainder.
Further#ore, in #ost countries !olatility tends to be lower in 'eriods when o'en interest
in stoc, index futures is hih )the only two cases of the o''osite results are aain the
6nited "tates and Ja'an*. -n so#e cases, !olatility is hiher in 'eriods when futures
!olu#e is hih, but this is dri!en by the unex'ected co#'onent of !olu#e, not the
ex'ected co#'onent. +oard, "and#ann and "utcliffe )2111* criti<ued the traditional
econo#etric tests ):A$CA, A$-0A etc.* for bein inconclusi!e and #isleadin and
instead used elaborate stochastic !olatility #odels that 'ro!ided no e!idence for
hy'othesis that F/"E 111 futures tradin instantly destabili9es the s'ot #ar,et. /here
are relati!ely few studies that analy9e the tradin !olu#e !ersus 'rice !olatility in the
context of currency futures. &es'ite the si9e of the currency #ar,et and the fact that
futures contracts are only one of three 'o'ular #eans with which s'eculators and
heders can assu#e 'ositions on future exchane rates )the other two bein currency
forwards and o'tions*, there are so#e indications that the le!el of futures tradin #ay
affect currency 'rice !olatility. "o#e of the studies 'ro!ide e!idence on the increase in
the s'ot exchane rate !olatility due the tradin in currency futures. For instance, the
study by Chatrath, $a#chander and "on )199B* ex'licitly exa#ines the relationshi'
between le!el of currency futures tradin and the !olatility in the s'ot rates of the +ritish
'ound, Canadian dollar, Ja'anese yen, "wiss franc and &eutsche #ar,. /he
researchers 'ro!ide stron e!idence on the causality between futures tradin !olu#e
exchane rate !olatility, as it is found out that the tradin acti!ity in futures has a
'ositi!e i#'act on conditional !olatility in the exchane rate chanes, with a wea,er
feedbac, fro# the exchane rate fluctuations to the futures !olatility. 0oreo!er, futures
tradin acti!ity is found to decline on the day followin increased !olatility in s'ot
exchane rates. :ra##ati,os and "aunders )194B* studied the sa#e forein currency
futures traded on the -nternational 0onetary 0ar,et o!er the 'eriod of 19C431943. After
usin nu#erous causality tests, the researchers could not re=ect the null hy'othesis that
!olu#e )'rice !ariability* causes 'rice !ariability )!olu#e* D a findin that is consistent
with the 'resence of sinificant bidirectional causality in futures #ar,et transactions.
0any researchers studied also the 'articular effect that different rou's of in!estors in
futures can ha!e on the cash #ar,et. Accordin to Adrani and Chatrath )1994* the
o!erall rowth in currency futures co##it#ents has not caused exchane rates to be
#ore !olatile, but the sures in the 'artici'ation of lare s'eculators and s#all traders
do destabili9e the #ar,ets. 0oreo!er the conclusion is drawn that #arin re<uire#ents
that E'enali9eF s'eculators and s#all sa!ers #ay ser!e to 'ro#ote stability in the
#ar,et. /he recent study by +hara!a and 0alhotra )211C* focuses on tradin in
futures on four currencies o!er the ti#e 'eriod of 194232111. /he authors find e!idence
that day traders and s'eculators destabili9e the #ar,et for futures. Further#ore it is
inconclusi!e whether heders stabili9e or destabili9e the #ar,et. Exchane rate
#o!e#ents affect ex'ected future cash flow by chanin the ho#e currency !alue of
forein cash inflows and outflows and the ter#s of trade and co#'etition. Aence, the
usae of currency deri!ati!es for hedin the unex'ected #o!e#ent of currency
beco#es #ore i#'ortant and essential and its i#'ortance is heihtened. Literature has
established that currency ris, can be #ini#i9ed throuh futuresGforward hedin )"olni,
)19C;*, +lac, )1991*, :len and Jorion )1993*, and Chan and Hon )2113**. Early
research illustrated the benefits of con!entional hedin strateies )Ederinton )19C9*
and Aill and "chneeweis )1942*, a#on #any others*. $ecent research reconi9es the
ti#e !aryin nature of exchane ris, and ado'ts :A$CA )enerali9ed autoreressi!e
conditional heteros,edasticity* #odels to enerate dyna#ic hedin strateies )Kroner
and "ultan )1993*, Lien, /se, and /sui )2112*, :uo )2113**.
Aowe!er there is no direct e!idence that deri!ati!es are actually used to hede.
Aentchel and Kothari )199C* and "i#,ins and Laux )199C* exa#ine directly fir#Is use of
currency deri!ati!es. /he for#er doesnIt find any e!idence and latter finds only wea,
e!idence that their use influence ex'osure. &eri!ati!es can also be used for s'eculati!e
'ur'oses. /he debacle story of 0etallesellschaft and its reasons are well ,nown to
e!eryone. /his s'eculation can also increase the #ani'ulation of #ar,et by bi 'layers
and hence can increase the !olatility in s'ot #ar,et )Ku#ar and "e''i )1992*, Jarrow
)1992**. "o there can be the case that currency future tradin acti!ity increases the s'ot
!olatility.
S!t"on II
'#1 Dr"%at"%( "n In)"a
&eri!ati!e is a 'roduct whose !alue is deri!ed fro# the !alue of one or #ore
basic !ariables, called bases )underlyin asset, index, or reference rate*, in a
contractual #anner. -n the -ndian context the "ecurities Contracts )$eulation* Act,
19@B )"C)$*A* defines Jderi!ati!eJ to include3
1. A security deri!ed fro# a debt instru#ent, share, loan whether secured or unsecured,
ris, instru#ent or contract for differences or any other for# of security.
2. A contract which deri!es its !alue fro# the 'rices, or index of 'rices, of underlyin
securities.
&eri!ati!es are securities under the "C)$*A and hence the tradin of deri!ati!es
is o!erned by the reulatory fra#ewor, under the "C)$*A.
/he ter# deri!ati!e has also been defined in section ;@6)a* of the $+- Act as
follows:
-n instr%ment( to be settled at a f%t%re date( whose val%e is derived from change
in interest rate( foreign exchange rate( credit rating or credit index( price of sec%rities
(also called .%nderlying/)( or a combination of more than one of them and incl%des
interest rate swaps( forward rate agreements( foreign c%rrency swaps( foreign c%rrency,
r%pee swaps( foreign c%rrency options( foreign c%rrency,r%pee options or s%ch other
instr%ments as may be specified by the 0an# from time to time&
&eri!ati!e contracts ha!e se!eral !ariants. /he #ost co##on !ariants are
forwards, futures, o'tions and swa's.
'#' Part"!"*ant( "n Dr"%at"%( Mar+t
/he followin three broad cateories of 'artici'ants 3 heders, s'eculators, and
arbitraeurs trade in the deri!ati!es #ar,et. Aeders face ris, associated with the 'rice
of an asset and they use futures or o'tions #ar,ets to reduce or eli#inate this ris,.
"'eculators wish to bet on future #o!e#ents in the 'rice of an asset. Futures and
o'tions contracts can i!e the# an extra le!eraeK that is, they can increase both the
'otential ains and 'otential losses in a s'eculati!e !enture. Arbitraeurs are in
business to ta,e ad!antae of a discre'ancy between 'rices in two different #ar,ets. -f,
for exa#'le, they see the futures 'rice of an asset ettin out of line with the cash 'rice,
they will ta,e offsettin 'ositions in the two #ar,ets to loc, in a 'rofit.
'#, E!onom"! -$n!t"on o- Dr"%at"%( Mar+t
-n s'ite of the fear and criticis# with which the deri!ati!e #ar,ets are co##only
loo,ed at, these #ar,ets 'erfor# a nu#ber of econo#ic functions.
1. (rices in an orani9ed deri!ati!es #ar,et reflect the 'erce'tion of #ar,et 'artici'ants
about the future and lead the 'rices of underlyin to the 'ercei!ed future le!el. /he
'rices of deri!ati!es con!ere with the 'rices of the underlyin at the ex'iration of the
deri!ati!e contract. /hus deri!ati!es hel' in disco!ery of future as well as current 'rices.
2. /he deri!ati!es #ar,et hel's to transfer ris,s fro# those who ha!e the# but #ay not
li,e the# to those who ha!e an a''etite for the#.
3. &eri!ati!es, due to their inherent nature, are lin,ed to the underlyin cash #ar,ets.
/he underlyin #ar,et witnesses hiher tradin !olu#es with the introduction of
deri!ati!es, because of 'artici'ation by #ore 'layers who would not otherwise
'artici'ate for lac, of an arrane#ent to transfer ris,.
;. "'eculati!e trades shift to a #ore controlled en!iron#ent of deri!ati!es #ar,et. -n the
absence of an orani9ed deri!ati!es #ar,et, s'eculators trade in the underlyin cash
#ar,ets.
@. An i#'ortant incidental benefit that flows fro# deri!ati!es tradin is that it acts as a
catalyst for new entre'reneurial acti!ity. /hey often eneri9e others to create new
businesses, new 'roducts and new e#'loy#ent o''ortunities, the benefit of which are
i##ense.
'#. C$rrn!/ F$t$r(
Currency futures are a linear 'roduct. -t #eans that the losses as well as 'rofits
for the buyer and the seller of a futures contract are unli#ited.
As the date of ex'iration co#es near, the basis reduces 3 there is a convergence of the
futures 'rice towards the s'ot 'rice. %n the date of ex'iration, the basis is 9ero. -f it is
not, then there is an arbitrae o''ortunity. Arbitrae o''ortunities can also arise when
the basis )difference between s'ot and futures 'rice* or the s'reads )difference
between 'rices of two futures contracts* durin the life of a contract are incorrect
2
.
2
-ncorrect #eans if the 'rice is not e<ual to the Lfair !alueI of the contract
-n deter#inin 'rofits and losses in futures tradin, it is essential to ,now both the
contract si9e )the nu#ber of currency units bein traded* and also the !alue of tic,. A
tic, is the #ini#u# tradin incre#ent or 'rice differential at which traders are able to
enter bids and offers. /ic, !alues differ for different currency 'airs and different
underlyin.
Currency futures can be cash settled or settled by deli!erin the res'ecti!e obliation of
the seller and buyer. All settle#ents howe!er, unli,e in the case of %/C #ar,ets, o
throuh the exchane.
'#0 Rat"ona1 -or Intro)$!"n2 C$rrn!/ F$t$r(
Futures #ar,ets were desined to sol!e the 'roble#s that exist in forward
#ar,ets. A futures contract is an aree#ent between two 'arties to buy or sell an asset
at a certain ti#e in the future at a certain 'rice. +ut unli,e forward contracts, the futures
contracts are standardi9ed and exchane traded. /o facilitate li<uidity in the futures
contracts, the exchane s'ecifies certain standard features of the contract. A futures
contract is standardi9ed contract with standard underlyin instru#ent, a standard
<uantity and <uality of the underlyin instru#ent that can be deli!ered, )or which can be
used for reference 'ur'oses in settle#ent* and a standard ti#in of such settle#ent. A
futures contract #ay be offset 'rior to #aturity by enterin into an e<ual and o''osite
transaction.
/he standardi9ed ite#s in a futures contract are:
Muantity of the underlyin
Muality of the underlyin
/he date and the #onth of deli!ery
/he units of 'rice <uotation and #ini#u# 'rice chane
Location of settle#ent
/he rationale for introducin currency futures in the -ndian context has been outlined
in the $e'ort of the -nternal Hor,in :rou' on Currency Futures )$eser!e +an, of
-ndia, A'ril 2114* as follows:
/he rationale for establishin the currency futures #ar,et is #anifold. +oth residents
and non3residents 'urchase do#estic currency assets. -f the exchane rate re#ains
unchaned fro# the ti#e of 'urchase of the asset to its sale, no ains and losses are
#ade out of currency ex'osures. +ut if do#estic currency de'reciates )a''reciates*
aainst the forein currency, the ex'osure would result in ain )loss* for residents
'urchasin forein assets and loss )ain* for non residents 'urchasin do#estic assets.
-n this bac,dro', un'redicted #o!e#ents in exchane rates ex'ose in!estors to
currency ris,s. Currency futures enable the# to hede these ris,s. 5o#inal exchane
rates are often rando# wal,s with or without drift, while real exchane rates o!er lon
run are #ean re!ertin. As such, it is 'ossible that o!er a lon D run, the incenti!e to
hede currency ris, #ay not be lare. Aowe!er, financial 'lannin hori9on is #uch
s#aller than the lon3run, which is ty'ically inter3enerational in the context of
exchane rates. As such, there is a stron need to hede currency ris, and this need
has rown #anifold with fast rowth in cross3border trade and in!est#ents flows. /he
aru#ent for hedin currency ris,s a''ear to be natural in case of assets, and a''lies
e<ually to trade in oods and ser!ices, which results in inco#e flows with leads and las
and et con!erted into different currencies at the #ar,et rates. E#'irically,
chanes in exchane rate are found to ha!e !ery low correlations with forein e<uity
and bond returns. /his in theory should lower 'ortfolio ris,. /herefore, so#eti#es
aru#ent is ad!anced aainst the need for hedin currency ris,s. +ut there is stron
e#'irical e!idence to suest that hedin reduces the !olatility of returns and indeed
considerin the e'isodic nature of currency returns, there are stron aru#ents to use
instru#ents to hede currency ris,s.
S!t"on III
,#1 Data an) Mtho)o1o2/
/ill January 2111, $+- had 'er#itted futures only on the 6"&3-5$ rates. Exchane3
traded currency futures ha!e been ex'anded to the euro, 'ound and yen 'airin since
January 2111.
For the 'resent analysis, we ha!e concentrated on the 6"&3-5$ currency futures
only. /his 'a'er will be usin the secondary data. &ata on s'ot exchane rate of -ndian
$u'ee !is383!is 6" &ollar has been collected fro# 5ational "toc, Exchane )5"E*.
5ear #onth ex'iry futures data fro# 5"E is used in the analysis as the tradin is #ore
for near #onth ex'iry futures. A total of C12 obser!ations of exchane rate were ta,en
startin fro# 12 A'ril, 211C to 11
th
February, 2111. &ata for exchane rate futures starts
fro# 29 Auust, 2114 to 11 February, 2111.
Firstly, returns for currency were calculated as followin :
$
t
N 111 O ln)"
t
G "
t31
*
Hhere, "
t
N "'ot exchane rate at ti#eLtI
/o identify the la lenth and #odel return series, the "-C infor#ation criteria
were calculated for las one to six and la order of 1 was found a''ro'riate. L=un3+ox
M stats were chec,ed to chec, for any heteroscedasticity in the errors series which is
co#'le#ented by A$CA L0 test. Aeteroscedasticity is then #odeled usin A$CA3
:A$CA #odels. Conditional !olatility is esti#ated usin the reression
$t N P1 Q P1$t31 Q R
t
)1*
)2*

)3*
Hhere, >
t
is white noise i.i.d 'rocess with E)>
t
* N 1 and E) * N 1
As 'roxy for the futures tradin acti!ity S%-
t
, the futures daily tradin !olu#e S
t
is
standardi9ed by the futures o'en interest %-
t
);*
Chatrath, $a#chander and "on )199B* suest that S%-
t
reflects s'eculati!e acti!ity.
%'en interest larely reflects hedin acti!ity because of its Tloner than3 intradayT
character. &aily tradin !olu#e re'resents s'eculation because of its short ter#
character. +y standardi9in the !olu#e by the o'en interest, an indicator of the
relationshi' between s'eculati!e and hedin acti!ity is constructed. /hen :raner
causality test were done for ht and S%-
t
. A ,ey benefit of usin the ratio, accordin to
:arcia et al. )194B*, is to a!oid the 'otential ex'iration effects on tradin acti!ities, since
daily tradin !olu#e and o'en interest are both functions of ti#e to ex'iration.
Additionally, +esse#binder and "euin )1993* suest that the !olu#e3o'en interest
ratio can 'ro!ide insihts into the tradin acti!ity enerated by either s'eculators or
heders in the #ar,et. Finally, Luu and 0artens )2113* 'oint out that usin this ratio to
#easure tradin acti!ities can better ca'ture the infor#ation arri!al than tradin !olu#e
or o'en interest alone.
$eaction of the s'ot #ar,et to the introduction of currency futures is exa#ined by
co#'arin the s'ot !olatility before and after the introduction of futures by ta,in the
window of 3BB obser!ations before and after the e!ent.
/he abo!e fiure 'resents the ra'h of s'ot returns $
t
. /he au#ented &ic,ey
Fuller )A&F* statistics are neati!e and sinificant at the 1'er cent le!elK the null
hy'othesis of non stationarity of the series is re=ected. -t is interestin to note the low
le!el of #ean and hih standard error of the returns. /his suests lare !olatility in the
currency exchane rate.
/o in!estiate whether a :A$CA #odel is a''ro'riate for #odelin the
!ariability of the exchane rates discussed, se!eral tests are carried out. /he residuals
of the reression
$t N P1 Q P1$t31 Q R
t
were chec,ed for linear de'endencies. /o chec, for the 'resence of A$CA effect in the
data we loo, at L=un3+ox )L+* M3stat of the s<uared residual obtained fro# the &:(
)&ata :eneratin (rocess* esti#ated abo!e. L+ M3stat for the !arious las are
sinificant, suestin 'resence of A$CA effect. 0ore for#al test for the 'resence of
A$CA effect is done usin A$CA L0 test. 5ull of no A$CA effect is re=ected at !arious
las. /o ca'ture this ti#e !aryin heteroscedasticity we 'roceed to #odel it usin the
#ost suitable A$CA fa#ily of #odel. -n liht of all these testsK heteroscedasticity needs
to be #odeled.
Later on other dianostic tests were conducted on the standardi9ed residuals >
t
fro# e<uation )2*

);*
where is the residual fro# e<uation )1* and h
t
is the esti#ated !ariance fro#
e<uation )3*. /he :A$CA #odel is correctly s'ecified if >
t
has a 9ero #ean and unit
!ariance. Further#ore there should be no autocorrelation in the >
t
series.
:A$CA)1,2* #odels the 'resence of A$CA effect i.e. it is able to #odel the
!aryin heteros,edasticity 'arsi#oniously. /he esti#ated e<uations i.e. #ean e<uation
and the !ariance e<uation has been i!en in the A''endix.
After ha!in obtained the #easure for exchane rate !olatility throuh the
:A$CA #odel which is h
t
, and the futures tradin acti!ity !ariable which is S%-
t
, the
#ain <uestion is to chec, whether both !ariables ha!e an influence on each other.
Aence both are 'ut to test for :raner causality to in!estiate the relationshi' between
s'ot !olatility and futures tradin acti!ity. /able 1 in the A''endix 'resents the :raner
causality test statistics. $esults indicate that there is a two3way causality between
exchane rate !olatility and futures tradin acti!ity.
$eaction of the s'ot #ar,et to the introduction of currency futures is exa#ined by
co#'arin the s'ot !olatility before and after the introduction of currency futures. /able
2 in the A''endix 'resents the results. /he null hy'othesis of !olatility of s'ot exchane
rate before the introduction of currency futures to be e<ual to !olatility of s'ot exchane
rate after the introduction of currency futures is re=ected at 1'er cent le!el of
sinificance. Alternate hy'othesis of !olatility of s'ot exchane rate before the
introduction of currency futures not e<ual to !olatility of s'ot exchane rate after the
introduction of currency futures is acce'ted at 1'er cent le!el of sinificance. Also the
alternate hy'othesis of !olatility of s'ot exchane after the introduction of currency
futures rate is reater than !olatility of s'ot exchane rate before the introduction of
currency futures is acce'ted at 1 'er cent le!el of sinificance.
,#' Con!1$("on3
-n this 'a'er we ha!e tried to find a relationshi' between the exchane rate
!olatility and the tradin acti!ity in the currency futures. /radin in currency futures in
6"&3-5$ rates was 'er#itted at the ti#e when the financial crisis had hit the ad!anced
econo#ies. /he uncertain situation the lobal econo#y was oin throuh had a lot of
i#'act on the exchane rates. -n the e#'irical analysis, this 'a'er does not ta,e into
account the effect of the financial crisis. /houh accountin for the i#'act of the crisis
will definitely #a,e the results #ore robust. /he :raner causality test is i#'le#ented
to in!estiate the relationshi' between futures tradin acti!ity #easured by nu#ber of
contracts and total a#ount that is tradin !olu#e and the s'ot !olatility of exchane
rate. /he results show that there is a two3way causality between the !olatility in the s'ot
exchane rate affects the tradin acti!ity in the currency futures #ar,et. Hhile the
e#'irical results a''ear reasonably clear, one needs to ta,e into account the i#'act of
financial crisis to arri!e at any eneral conclusion about i#'act of currency futures on
s'ot exchane rate. $eardin the fact that de!elo'in countries #ay be !ulnerable to
self3fulfillin s'eculati!e attac,s and ad!erse de!elo'#ents in international financial
#ar,ets, the sinificance of this in!estiation about the 'otential role of futures tradin in
-ndian exchane rate stability is li#ited. Additional research is needed to obtain further
insihts into this issue. Further#ore, the i#'ulse res'onse and !ariance
deco#'osition #odels can be used to how shoc,s in !ariables are trans#itted o!er
ti#e.
Appendix
He fit the &ata eneratin 'rocess. A$)1* describes the series well.
E(t"mat"on E4$at"on3
$E/6$5" N C)1*O$E/6$5")31*
Sariable Coefficien
t
"td.
Error
t3"tatistic (rob.
$E/6$5")31*
1.14 1.1; 2.1; 1.13
/o chec, for the 'resence of A$CA effect in the data we loo, at L=un3+ox M3stat of the
s<uared residual obtained fro# the &:( esti#ated abo!e. L+ M3stat for the !arious las
are sinificant, suestin 'resence of A$CA effect. 0ore for#al test for the 'resence of
A$CA effect is done usin A$CA L0 test. 5ull of no A$CA effect is re=ected at !arious
las. )see table*. /o ca'ture this ti#e !aryin heteroscedasticity we 'roceed to #odel it
usin the #ost suitable A$CA fa#ily of #odel.
:A$CA)1,1* #odels the 'resence of A$CA effect i.e is able to #odel the !aryin
heteroscedasticity 'arsi#oniously. /he esti#ated e<uation is:
Man 4$at"on3
$E/6$5" N C)1*O$E/6$5")31*
Var"an! 4$at"on3
:A$CA N C)2* Q C)3*O$E"-&)31*U2 Q C);*O:A$CA)31* Q C)@*O:A$CA)32*
R($1t "( *r(nt) "n th ta51 51o&3
Sariable Coefficient "td. Error 93
"tatistic
(rob.
$)31* 1.1B@;41 1.1;139C 1.@41C9
C
1.113C
Sariance
E<uation
C 1.111@;; 1.1111C1 3.14C;B
1
1.111;
$E"-&)31*U2 1.11B919 1.11CBC@ B.1;4;9
@
1
:A$CA)31* 1.3113;2 1.14@13B 1.BCC21
;
1.193@
:A$CA)32* 1.@CB499 1.1CBB29 3.2BB1B
;
1.1111
$3s<uared 1.11@432 0ean
de'endent
!ar
1.11;@4
1
Ad=usted
$3 s<uared
1.111191 ".&.
de'endent
1.22C2@
4
".E. of reression 1.22C23B A,ai,e
info
3
1.334;;
2 "u# s<uared resid 3B.;13@B "chwa
r9
3
1.31B29
2 Lo li,elihood 12@.1;B9 Aannan3
Muinn
criteria
3
1.32B12
2 &urbin3
Hatson stat
1.9C24BB
/he coefficients in the !ariance e<uation are 'ositi!e and sinificant also su# of the
coefficients associated with the A$CA and :A$CA ter# is less than one. LJ65: +%V
M3stat is insinificant for !arious las. "usetin that the hetrocedasticity has been
#odeled 'ro'erly. A$CA L0 test for las 1, ;, 4 and 12 las also suests that there is
no A$CA effect left in the data.
P1ot o- th (t"mat) %o1at"1"t/ "(3
(airwise :raner Causality /ests
Las:
3
5ull Ay'othesis: %bs F3"tatistic (rob.
S%- does not :raner
Cause
S%LA/-L-/
22
3
2.B
3
1.1
@
S%LA/-L-/W does not :raner
Cause
S
2.;
3
1.1
C
/able: 1 :raner Causality /est
/able: 2 &ifference in Solatility
0ethod df Salue (robabilit
y t3test C14.11 2;.11 1.11
"atterthwaite3Helch t3testO ;24.21 23.B9 1.11
Ano!a F3test )1, C14* @41.22 1.11
Helch F3testO )1,
;24.21
2*
@B1.19 1.11
O/est allows for une<ual cell !ariances
Analysis of Sariance
"ource of Sariation df "u# of
"<.
0ean
"<.
+etween 1.11 1.;9 1.;9
Hithin C14.11 1.B1 1.11
/otal C19.11 1.19 1.11
Cateory "tatistics
"td. Err.
Sariable Count 0ean "t
d.
of 0ean
S%LA/-L-/WX(ost 3;C.11 1.14 1.1; 1.11
S%LA/-L-/WX(re 3B3.11 1.13 1.11 1.11
All C11.11 1.1@ 1.1; 1.11
Pro)$!t D-"n"t"on 3
Contra!t S*!"-"!at"on -or US Do11ar( 6 In)"an R$* 7USDINR8
C$rrn!/ F$t$r(
Contra!t (*!"-"!at"on 3 USD INR C$rrn!/ Dr"%at"%(
6nderlyin $ate of exchane between one 6"& and -5$
Exchane of tradin 5ational "toc, Exchane of -ndia Li#ited
"ecurity descri'tor F6/C6$ 6"&-5$
Contract si9e 6"& 1111
Muotation
Currency futures contract would be <uoted in $u'ee
ter#s. Aowe!er, the outstandin 'ositions would be in
dollar ter#s.
/ic, si9e $e. 1.112@
(rice bands 5ot a''licable
/radin cycle /he futures contracts will ha!e a #axi#u# of twel!e
#onths tradin cycle. 5ew contract will be introduced
followin the Ex'iry of current #onth contract.
Ex'iry day Last wor,in day of the #onth )sub=ect to holiday
calendars*
Last /radin &ay /wo wor,in day 'rior to contract Ex'iration &ate
"ettle#ent basis &aily #ar, to #ar,et settle#ent will be on a / Q1
basis and final settle#ent will be cash settled on /Q2
basis.
"ettle#ent 'rice &aily #ar, to #ar,et settle#ent 'rice will be the
closin 'rice of the futures contracts for the tradin
day and the final settle#ent 'rice shall be the $+-
reference rate on last tradin date.
"ettle#ent Cash settled
Final "ettle#ent (rice /he reference rate fixed by $+- two wor,in days 'rior
to the final settle#ent date will be used.
L"m"tat"on( o- F$t$r(3
3 /he benefit of standardi9ation which often leads to i#'ro!in li<uidity in futures, wor,s
aainst this 'roduct when a client needs to hede a s'ecific a#ount to a date for which
there is no standard contract
3 Hhile #arinin and daily settle#ent is a 'rudent ris, #anae#ent 'olicy, so#e
clients #ay 'refer to not incur this cost in fa!or of %/C forwards, where collateral is
usually not de#anded
R-rn!(
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