Article

Impact of Introducing Different Paradigm

18(2) 135–153
Financial Derivative Instruments in © 2014 IMT
SAGE Publications
India on Its Stock Market Volatility Los Angeles, London,
New Delhi, Singapore,
Washington DC
DOI: 10.1177/0971890714558704
http://par.sagepub.com

Suparna Nandy (Pal)

Arup Kr. Chattopadhyay

Abstract
The impact of the introduction of derivative trading in the forms of stock index futures, stock index
options, currency futures and interest rate futures in India over time on the underlying stock mar-
ket volatility is examined here using data on daily closing prices of S&P CNX Nifty in a Generalized
Autoregressive Conditional Heteroscedastic (GARCH) (1, 1) framework, capturing heteroscedasticity
in stock market return. Our estimation period spans from 1 April 1996 to 31 March 2012. The results
suggest that there is time-varying persistence of the stock market volatility throughout the estima-
tion period. Further, the introduction of equity derivatives in the forms of stock index futures and
stock index options and interest rate futures in the currency derivative segment have found to be
successful in reducing the stock market volatility in India, whereas introduction of currency futures is
observed to have a destabilizing impact on the stock market volatility of the country. The probable
reasons behind these findings of the study are as follows: Derivative instruments are introduced on
the general expectation of controlling risk, hence the volatility in the underlying spot market, which
happened in the cases of equity derivatives. Same occurred in case of interest rate derivative because
this instrument is expected to bring stabilization in interest rates, hence stock prices. But the ineffec-
tiveness of currency futures in stabilizing the stock prices might happen due to excessive involvement
of speculators in the foreign exchange market and current integration of the Indian economy with the
rest of the world.

Keywords
Financial derivative, volatility, GARCH (1, 1), heteroscedasticity, persistence

Introduction
A stock market with its primary and secondary segments assists business and government in raising
funds, and investors to maximize their returns subject to their tolerance for risk. An organized
secondary market, where already issued securities are traded, facilitates and boosts investors’

Suparna Nandy (Pal), Assistant Professor, Department of Economics, Vidyasagar Evening College, Kolkata,
West Bengal, India. E-mail: supa_nandi@rediffmail.com
Arup Kr. Chattopadhyay, Professor, Department of Economics, University of Burdwan, Burdwan, West Bengal,
India. E-mail: arup.chatto@yahoo.co.in
136 Suparna Nandy (Pal) and Arup Kr. Chattopadhyay

participation as the market provides liquidity for the investors. On one hand, a vibrant and stable
secondary market with high return and low risk also boosts up primary market in generating new
funds. On the other hand, volatile secondary market lowers the investors’ confidence and disturbs the
primary market resulting into reduced collection of new funds by the issuers, implying capital market
inefficiency. Resource allocation depends on efficiency of market. Capital resources are properly
utilized if efficient firms can gather more capital easily in comparison to weak firms. In an efficient
market, information is properly impounded which is reflected by stock prices. But inefficiency in the
stock market may arise due to operational inefficiency and also due to the opportunistic activities of
the cash as well as derivative market players resulting into destabilization of spot prices. Increasing
stock market volatility is not desirable as this adversely affects growth of firms, generation of
employment and ultimately economic prosperity.
Since early 1990s, economic liberalization and globalization of Indian economy have increased the
degree of integration of the Indian capital market with the world market and necessitated to undertake
major transformations and reforms in the stock markets of the country in terms of establishment of
Security and Exchange Board of India (SEBI), introduction of disclosure norms, dematerialization of
securities, online trading with country-wide network, increasing participation of foreign institutional
investors, allowing “value at risk” based margin trading, reduction in rolling settlement period from
T + 5 to T + 2, introduction of new financial instruments and so on. With these landscapes like
changes in the Indian financial sector, volume of trading has increased significantly making Indian
capital market comparable with that of the other developed markets and it also becomes the largest
among emerging markets. As a result, the demand for the international money and financial instruments
increased significantly. In this respect, changes in exchange rates, interest rates and stock prices of
different financial markets due to collapse of Bretton Woods system, supremacy of monetarism over
Keynesianism, deregulations of interest and exchange rates, frequent upsurge of oil prices, etc. have
also increased the financial risks to the corporate world. These events have also led to manifold
increase in the price–volume volatility of the stock market causing a more risky situation to the
market participants.
To manage such risks, the new financial instruments have been developed in the financial markets,
which are also popularly known as financial derivatives. The basic purpose of these instruments is to
provide commitments to prices for future dates for giving protection against adverse movements in
future prices, in order to reduce the extent of financial risks. Following the growing instability in the
financial markets, the financial derivatives gained importance after mid-1970s. Derivative market
enriches investors and issuers with a wider range of tools for risk management and capital accumulation.
These tools also help improve the allocation of credit and the distribution of risk in the global economy,
thereby decreasing the cost of capital formation and motivating economic growth. In India, the emergence
as well as growth of derivatives market is relatively a recent phenomenon.
In India, derivatives in the form of stock index futures were introduced on 12 June 2000, followed
by index options on 4 June 2001, and options and futures on individual securities in July 2001 and
November 2001, respectively, both in BSE and NSE. NSE launched currency futures trading in INR–US$
on 29 August 2008. Till January 2010, exchange rate futures contract was available only for US dollar
vis-à-vis Indian rupee. Exchange-traded currency futures have now been extended to the euro, pound
and yen pairing. The SEBI also allowed the trading on interest rate futures contracts (FUTINT) in F&O
segment in 27 June 2003 but discontinued it from 28 August 2009 as the market response was tepid.
FUTINT in the currency derivative segment was reintroduced on and from 31August 2009.

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Impact of Introducing Different Financial Derivative Instruments in India 137

During the early 1990s, India initiated a series of structural reforms in the foreign exchange market.
The journey away from a pegged exchange rate regime to partially floated one in 1992 and fully floated
in 1993 was directed towards developing a market-determined exchange rate of the rupee and was an
important step in the progress towards full current account convertibility. To cope up with the international
standards, a well-developed foreign exchange derivative market was essential. With the increased
volatility in exchange rate and to mitigate the risk arising out of excess volatility, currency futures
contract was introduced on the expectation that it would help in hedging the exposures (i.e., risks) of
exchange rate arising out of its unfavourable movements.
Economic activities in a country are very much influenced by the behaviour of the real exchange rate.
A fall in the real exchange rate (i.e., devaluation) increases the competitiveness of domestic goods
against foreign goods and thus has a positive effect on country’s balance of trade considering unchanged
structure of elasticities (as per Marshall–Larner condition). This, in turn, increases domestic aggregate
demand leading to higher level of output. Again there is an influence of economic activities on stock
prices. The expected future cash flows from stock depend on future domestic as well as foreign aggregate
demand. Therefore, while determining prices of stocks, present and future expected economic activities
should be taken into account. Furthermore, if domestic currency depreciates (appreciates) against the
foreign currency, the exposure would result in gain (loss) for export-oriented companies as their
competitiveness would improve (deteriorate). This is also true for IT companies selling services, whose
earnings are denominated by foreign currencies. Therefore, their stock prices would increase (fall). But
for those companies necessitating imported equipments, raw materials, etc., domestic currency
depreciation (appreciation) would result in loss (gain) as their cost of production would then increase
(decrease). Their stock prices would then fall (rise). In this backdrop, unpredicted movements in
exchange rates expose the corporate sector, and therefore also the investors, to currency risks. Currency
futures enable them to hedge these risks.
Volatile interest rates affect cost of borrowing of the corporate sector and thereby influence their
profitability. These would lead to fluctuation in stock prices. Interest rate futures would enable better risk
management by helping corporate bodies to guard against interest rates’ volatility. It is to be noted in this
connection that interest rates being prices of loanable funds and also perceived discount rates used for
computing prospective yields affect the stock market.
Thus, the objective of introducing all these financial derivatives in India’s financial market was to
curb the increasing volatility in the asset prices, bring about sophisticated risk management tools
leading to higher returns by reducing risk and transaction costs as compared with individual financial
assets. Moreover, these products are not only used as hedging tools, but are also used for availing
arbitraging opportunities to correct mispricing in the asset market and also speculative opportunities by
risk-taking investors. These kinds of uses of derivative products are believed to be supportive in
building up a strong relationship between the cash and derivative market segments leading to more
efficient price discovery in both the markets. It is also thought that introduction of derivative products
would increase liquidity in the markets and bring operational efficiency in the market dominated by
informed institutional investors. Besides these benefits, certain threats are also connected with
derivative trading. Low trading cost and leveraged trading are major attractions for speculators in
derivative markets. Since the derivatives market segment provides good speculative opportunities and
excessive speculative trading, these might increase the volatility of the market as well. There is still
disagreement as to whether derivatives’ trading increases or decreases the volatility of spot prices in
India which is an empirical research question. Some researchers argue that derivative trading reduces

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138 Suparna Nandy (Pal) and Arup Kr. Chattopadhyay

the volatility through better price discovery. On the other hand, others claim that volatility increases after
the introduction of derivative trading due to increased speculative activities. Therefore, in this study we
seek answers to questions like: What is the nature of time-varying volatility in the Indian stock market?
What is the effect of introduction of futures, options, currency and interest rate derivative trading on
volatility of stock market return in India? A modest attempt has been made here to answer these questions.

Brief Literature Survey

In the relevant literature, there are mainly two types of theory explaining the impact of derivative trading
on the underlying stock market. Some argue that introduction of derivative trading increases the spot
market volatility and thereby destabilizes the underlying market. While there are others who argue that
the introduction of derivatives reduces the spot market volatility and thereby stabilizes the market.
Comparing daily return volatilities during the pre-futures and post-futures period between S&P 500
and non-S&P 500 group of stocks, Harris (1989) has argued that increase in post-future volatility in the
cash market may not be due to index futures by themselves but due to other index-related phenomena,
such as, the growth in foreign ownership of equities and the growth in index funds. Using both parametric
and nonparametric tests, Kamara et al. (1992) examined whether there were any changes in the volatility
of S&P 500 index due to futures trading introduction for the period 1976–1987. Along with F-tests the
authors used the Kolmogorov–Smirnov two-sample test and Wilcoxon Rank sum test to examine whether
dispersion was significantly higher in the post-futures period. They noticed higher daily return volatility
in the post-futures period though monthly return volatility was found to be unchanged. Antoniou and
Holmes (1995) examined the impact of trading in the FTSE-100 stock index futures on the volatility of
the underlying spot market in UK utilizing GARCH family of econometric techniques. They observed
that the spot market was more volatile in the post-futures period which, according to them, was the result
of increase in the rate of information flow to the spot market and not due to speculators having adverse
destabilizing effects. Chang, Cheng and Pinegar (1999) examined the consequence of index futures
listing on the underlying stocks by dividing the portfolio volatility into two parts, namely, the average
volatility of constituent stocks and the cross-sectional dispersion of returns. The authors found that after
the listing of Nikkei 225 futures in Japan there was a decreasing cross-sectional dispersion of return
across stocks in the index though the index volatility was found to increase proportionally more than the
average individual stock volatility. However, no similar impact was found for stocks outside the index
and no impact was found for the off-shore listing of Nikkei 225 futures in the Singapore market. Benilde
and Armada (2001) in their paper used daily closing price data of Portuguese Stock Index PSI-20 for the
period December 1992–December 1998 applying a GARCH model to measure the impact of futures
trading on spot market volatility. The authors found increased Portuguese stock market volatility due to
introduction of PSI-20 index futures, though they argued not to generalize their derived result as their
study had the limitations of not controlling for other influences on the volatility. Investigating the impact
of Universal Stock Futures introduction on the underlying market dynamics, Chau, Holmes and Paudyal
(2008) found lesser impact and persistence of news and greater asymmetry in the post-futures period
though from the control stock result they opined that those changes were not due to futures introduction.
T. W. James (1993) examined the impact of price discovery by futures market on the volatility of the
underlying cash market. For estimating the price discovery function of the futures market, the author has

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Impact of Introducing Different Financial Derivative Instruments in India 139

used the Garbade and Silber model, and from the estimated results the author has confirmed that futures
market has been beneficial to cash market since it has not only offered better efficiency and liquidity to
the cash market but also reduced its long-term cash volatility. Chatrath et al. (1995) evidenced a
stabilizing effect of trading of S&P 100 stock index options on the underlying stock index. Galloway and
Miller (1997) examined the effect of introduction of futures contract on the Midcap 400 stocks and
observed declining impact on the volatility of the underlying spot market.
Thenmozhi (2002) found that in India the volatility of Nifty in the post-futures period had been in the
declining trend which, according to the author, might be due to increased cash market liquidity resulting
from faster dissemination of information, shifting of speculators from cash to futures market for lower
transaction cost, high leverage, low margins, standardized contracts and trading conditions prevalent in
the futures market. Shenbagarman (2003) showed that futures and options trading in India had not led to
any significant change in the volatility of the underlying stock index though she observed changes in the
nature of volatility during the post-futures period. Raju and Karande (2003) found reduced volatility in
the cash market after introduction of stock index futures in India. Nath (2003) showed that the volatility
of the Indian stock market represented by Nifty, Nifty Junior and few individual stocks had reduced in
the post-derivative period. Vipul (2006) found the reduced volatility of the underlying stocks in the post-
derivative period which according to the author was because of the reduction in persistence of volatility
of previous day. Ray and Panda (2011) investigated the impact of derivatives introduction on the
underlying stock volatility and observed changes in the structure of volatility and longer persistence of
volatility in some of their sample stocks in the post-derivative period. In a recent study, using VAR and
VECM techniques, Gupta and Chattopadhyay (2013) have established both short-run and long-run
integration of the Indian stock market with the other domestic as well as foreign financial markets during
the post-reforms period.

Research Gap
As our study period covers quite a number of years before and after derivative trading introduced in
India, unlike earlier studies, using period analysis we can examine the impact of derivatives on the cash
market volatility in India, especially when the market has become relatively matured. Also, to the best of
our knowledge, there is hardly any study made in the Indian context examining the impact of introduction
of currency futures and FUTINT on the stock market volatility when financial markets are cointegrated.

Objective and Significance of the Study

Our main objective is to examine the following issues in respect of the Indian stock market for the period
spanning from 1 April 1996 to 31 March 2012:

1. To find any evidence of time-varying volatility in daily return of S&P CNX Nifty and also the
nature of the volatility process.
2. To examine the impact of introduction of futures trading on the volatility of the underlying stock
index in India.

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140 Suparna Nandy (Pal) and Arup Kr. Chattopadhyay

3. To examine the joint impact of introduction of both stock index futures and options trading on the
underlying spot market volatility and to compare this impact with the impact of introduction of
futures trading only.
4. To examine the impact of introduction of currency futures and FUTINT on the volatility of the
stock market.
5. To examine whether there is any significant difference in the stock market volatility with the
introduction of other derivatives over and above the equity derivatives (stock index futures and
stock index options).

This study deserves special significance on the following counts:

First, since the study period covers a number of years before and after derivative trading in India, it is,
therefore, possible to know from this study how much efficient the derivative market is in stabilizing
volatility in the stock market.
Second, the outcome of the study may guide the policy makers and market regulators to adopt appropriate
policies and measures so that the volatility can be lessened.
Third, knowledge about the price volatility in the Indian stock market is of great importance to investors,
portfolio managers including foreign institutional investors and other market players in formulating
suitable strategies.

Plan of the Paper

The remaining portion of the study is organized as follows: The sixth section outlines the data used in the
study along with the study period. The seventh section details the hypotheses to be tested, and econometric
and statistical techniques to be applied in testing the hypotheses. The eighth section enumerates the
analysis of the data and findings of the study, and finally the ninth section concludes the study and
presents directions for future research.

Study Period and Data Base

The study covers relatively a long period from 1 April 1996 to 31 March 2012, when major changes were
brought about in the structure and functioning of the Indian stock market. The S&P CNX Nifty index is
used as the representative the of Indian stock market which is a market capitalization weighted index of
50 stocks traded on the National Stock Exchange comprising of 23 sectors of the Indian economy. The
daily closing price data of S&P CNX Nifty is obtained from http://nseindia.com. Daily closing prices of
S&P500 and NIKKEI 225 (NIKKEI) as control variables are obtained from the website http://finance.
yahoo.com. We have collected the information regarding dates (mentioned earlier) of derivative
instruments’ [Index Future, Index Option, Currency Futures and Interest Rate Futures] introduction from
the circular archive of the NSE of India. The study is based on four groups of period: the the first group
includes (i) pre-futures period from 1 April 1996 to 9 June 2000 and (ii) post-futures period from 12 June
2000 (i.e., the date of onset of Nifty futures on NSE) to 31 March 2012. The second group includes

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Impact of Introducing Different Financial Derivative Instruments in India 141

(i) pre-option period from 1 April 1996 to 1 June 2001 and (ii) post-option period from 04 June 2001
(i.e., the date of introducing index options on NSE) to 31 March 2012. The third group consists of (i) the
period prior to the introduction of currency futures contracts, that is, from 01 April 1996 to 28 August
2008 and (ii) the post-currency futures’ introduction period from 29 August 2008 to 31 March 2012.
Lastly, the fourth group consists of (i) the pre-interest rate futures period from 1 April 1996 to 28 August
2009 and (ii) the post-interest rate futures period from 31August 2009 to 31 March 2012.
The daily price series consists of 4,179 data points out of which 1,098 observations are pertaining to
the pre-futures period, and 3,081 data points are pertaining to the post-futures period. Out of 4,179 data
points 1,352 observations are pertaining to the pre-options period, and 2,827 data points are pertaining
to the post-options period. 3,243 observations constitute the pre-currency futures and 936 observations
constitute the post-currency futures period, whereas out of 4,179 data points 3,502 observations belong
to the period of pre-interest rate futures’ introduction and 677 observations belong to the period of post-
interest rate futures’ introduction.

Methodology
We have set the following hypotheses for accomplishing the objectives of the study:

1. There is time-varying volatility in Nifty daily return throughout the study period.
2. The introduction of futures and options has led to decrease in volatility in stock index return.
3. Volatility of Nifty has decreased further after the introduction of both currency futures and interest
rate futures along with the presence of equity derivatives.
4. Change in volatility of Nifty after currency futures’ introduction is more than change in volatility
after the introduction of only equity derivative.
5. Similarly, change in volatility of Nifty after interest rate futures’ introduction is more than change
in volatility after currency futures’ introduction.

If the above hypotheses are found to be true, we may conclude that introduction of derivatives trading in
India leads to the decline in the stock market volatility and thus the derivatives have a stabilizing effect
on the stock market volatility in the country.
In the study, return (R t) on which volatility has been estimated, is defined as:

Rt = loge (Pt / Pt–1) (1)

where Rt is continuous daily return at time t, and Pt–1 and Pt represent daily closing prices of an asset at
two successive days t–1 and t respectively.
Stationarity of all the return series has been checked using the ADF test (1979) statistic. We have
graphically plotted the daily return series over time by which volatility clustering, if any, can be checked.
We have calculated the coefficients of Skewness and Kurtosis to understand whether the return series is
skewed and leptokurtic or not. To test the null hypothesis of normality, Jarque–Bera (JB) statistic has
been applied. In the past studies findings of heteroscedasticity in stock returns are well documented. If
the error variance is not constant, that is, heteroscedastic, then OLS estimation is inefficient. Moreover,

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142 Suparna Nandy (Pal) and Arup Kr. Chattopadhyay

the tendency in financial data for volatility clustering can be well captured in a GARCH framework.
Therefore, we have modelled the time-varying conditional variance in our study as a GARCH process.
To be sure about the appropriateness of the GARCH type model for a given dataset, we have performed
the ARCH LM test (Engle, 1982) which is a Lagrange Multiplier (LM) test for detecting the presence of
ARCH effect in the residuals. Further, we use Akaike Information Criterion (AIC) to determine the order
of the GARCH model when AIC = (–2L/n + 2k/n, here k denotes the number of estimated parameters,
n = number of observations, L = the value of the log likelihood function using k estimated parameters
[Ref.- EViews 3.1 help system]. AIC suggests us to choose that lag length which leads to minimization
of the value of the information criterion.
Let yt–1 be the information set containing the realized values of all relevant variables (affecting Rt) up
to time t–1. As investors know the information set contained in yt–1 while making their investment
decision at the period t–1, the relevant mean return is the conditional expected value of Rt given yt–1 and
relevant volatility is the conditional variance of Rt given yt–1 which two are denoted respectively by
mt = E(Rt /yt–1) and ht = Var (Rt /yt–1). Therefore, return series Rt can be defined as:

Rt = E(Rt /yt–1) + et = mt + et (2)

where et (being Rt – mt), is the unexpected return at time t. A positive et means an unexpected increase in
price suggesting the arrival of good news, while a negative et means an unexpected decrease in price
suggesting the arrival of bad news. A large value of | et | implies the “significant” or big news producing
a large unexpected change in price. Actually, et is termed as white noise in econometrics.
Following Engle (1982) conditional variance ht can be modelled as a function of lagged e’s, that is,
predictable volatility is dependent on past news which is represented by the following ARCH (q) model:

ht = w + a1 e2t–1 + a2 et–2
2
+ · · · · · · · · · · · + aq e2t–q (3)

where w > 0, a1, a2, ...., aq ≥ 0 and et /yt–1 ~ N (0, ht). The parameter ai governs the effect of a return
shock i period ago (i ≤ q) on current volatility. For i > j, we would expect that ai < aj implying that the
older news has less effect on current volatility.
Following Bollerslev (1986) the GARCH (p¸ q) model is represented as:

Rt = a0 + a1 Rt–1 + et (4)
ht – a0 + ∑i=1
p
ai e2t–i + ∑qj=1 bj ht–j , (5)

where Equation (4) is the conditional mean equation and (5) is the conditional variance equation. Here
“p” is the order of ARCH term and “q” is the order of GARCH term. In the study we choose the order of
“p” and “q” by the AIC criterion. We consider 2 as the maximum lag length. According to AIC criterion,
we find the GARCH (1, 1) model as most suitable for our study. The impact of derivative introduction
on the stock market is examined in the study by modelling the time series of S&P CNX Nifty index in a
GARCH (1, 1) process. Therefore, we estimate the following conditional mean equation:

Rt, Nif = a0 + a1 Rt–1, Nif + et    et ~ N (0, ht), (6)

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Impact of Introducing Different Financial Derivative Instruments in India 143

where Rt,Nif and Rt–1,Nif are daily return and lagged daily return of Nifty, respectively. The residual [et] in
Equation (5) is assumed to be distributed N(0, ht) where the conditional variance ht is represented as:

ht = a0 + a1 e2t–1 + b1 ht–1. (7)

To address the issue of how the initial introduction of derivative instruments (stock index futures)
does have an impact on the cash market volatility, we introduce a dummy variable Df into the conditional
variance equation which takes on a value of zero before the derivatives were introduced and a value of
one thereafter. If the coefficient of the dummy g1 is found to be statistically significant, derivatives
introduction has an impact on the spot market volatility. Moreover, if this coefficient is statistically
significantly positive (negative) it implies that the derivative introduction leads to increasing (declining)
volatility in the associated spot market. Equation (6) then becomes:

ht = a0 + a1 e2t–1 + b1 ht–1 + g1 Df, (8)

where Df is a dummy variable taking a value of zero prior to the introduction of futures and a value of
one in the post-futures introduction period. The values of parameters a1 and b1 determine the short-run
dynamics of the resulting volatility of time series. If the value of GARCH lag coefficient b1 is significantly
large, the volatility is persistent in nature, whereas a large value of GARCH error coefficient a1 indicates
quite intensive reaction of volatility to market movements. If the value of a1 + b1 is close to unity, a
shock at time t will persist for many future periods implying a long memory.
To be sure whether introduction of futures contract is the sole responsible factor behind the changing
nature of volatility, we have isolated the influence of developed stock market and regional stock market
by considering S&P 500 and NIKKEI as additional regressors of the mean equation. Accordingly, we
introduce lag return in S&P 500 and NIKKEI as additional independent variables in the mean equation
of the GARCH (1, 1) model. We check the multicollinearity problem among the regressors by computing
correlation coefficients and testing accordingly. The augmented mean equation thus becomes:

Rt, Nif = a0 + a1 Rt–1, Nif + a2 Rt–1,SP + a3 Rt–1,NIK + et . (9)

To estimate the GARCH (1, 1) model, the maximum likelihood method is employed which can find
the most likely values of the parameters given the actual data with T observations. After specifying mean
and variance equation as mentioned above the log-likelihood function (LLF) is specified to maximize
under a normality assumption for the disturbances as:

lnL = –T/2 ln(2p) – 0.5 ∑t–1

T
ln ht – 0.5 ∑t–1
T
et2/ht . (10)

With the help of EViews software, the above LLF has been estimated to generate the parameter values
along with constructing their standard errors (Brooks, 2008, pp. 394–399: Enders, 2008, pp. 138–140).
We have examined the impact of introduction of option contract in the presence of futures contract
following the same procedure as that of futures contract modifying the conditional variance equation in
the following form:

ht + a0 + a1 e2t–1 + b1 ht–1 + g1 Df + g2 Do . (11)

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144 Suparna Nandy (Pal) and Arup Kr. Chattopadhyay

where Do is a dummy variable taking a value of zero prior to the introduction of options and a value of
one in the post option introduction period.
For examining the impact of currency futures introduction in the presence of stock index futures and
stock index options, the form of the conditional variance equation becomes:

ht + a0 + a1 e2t–1 + b1 ht–1 + g1 Df + g2 Do + g3 Dcd (12)

where Dcd is the dummy variable related to currency futures.

For examining the impact of introduction of Other Derivative instruments over and above the
introduction of equity derivatives on the stock market volatility in India, we consider futures and options
together as equity derivatives and introduce a single dummy variable in the conditional variance equation
to identify their impact, whereas two other dummy variables are introduced separately to examine the
impact of introduction of currency futures (Dcd) and interest rate futures (Dird) in the currency derivative
segment in the following form:

ht + a0 + a1 e2t–1 + b1 ht–1 + g1 Ded + g2Dcd + g3Dird , (13)

Where Df , Do , Ded , Dcd and Dird represent dummy variables corresponding to futures contract, equity
derivative, currency futures and FUTINT contracts respectively, taking the value zero for the period
prior to introduction of the particular derivative contract and one for the period after introduction of that
particular derivative contract.
After estimating the parameters of variance equation, we test whether the absolute difference in
Equity Derivative dummy coefficient ged and currency futures dummy coefficient gcd in Equation (13)
and also absolute difference in dummy coefficient of currency futures contract gcd and dummy coefficient
of interest rate futures contract gird in Equation (13) are statistically significant using the Wald statistic.
The Wald statistic here tests firstly, the null hypothesis that whether equity derivative dummy coefficient
ged is equal to the currency futures dummy coefficient gcd in Equation (13) and secondly, dummy
coefficient of currency futures contract gcd is equal to the dummy coefficient of Interest Rate Futures
contract gird in Equation (13). It is a chi-square test in which the null hypothesis is rejected if the calculated
value of test statistic is found to be greater than the table value of chi-square.

Data Analysis and Findings

To test the stationarity of daily return series of S&P CNX Nifty, S&P 500 and NIKKEI, the Augmented
Dickey–Fuller (ADF) unit root test is performed, the result of which is presented in Table 1. From
Table1, we can find that all the estimated values of ADF test statistic are statistically significant at
1 per cent level which implies that all the return series are stationary. The descriptive statistics on
returns of S&P CNX Nifty, S&P 500 and NIKKEI are summarized also in Table1. The coefficient of
skewness for all the return series is observed to be different from zero which indicates that return
distributions are not symmetric. The coefficient of Kurtosis for all the index return series is fairly high
suggesting that the underlying data is leptokurtic or heavily tailed and sharply peaked about the mean

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Impact of Introducing Different Financial Derivative Instruments in India 145

Table 1. Result of the ADF Test and Descriptive Statistics of Return Series of Selected Indices

ADF Test Coefficient of Coefficient Jarque-Bera

Index Statistic† Skewness of Kurtosis Test Statistic§
S&P CNX Nifty –28.34010 –0.169800 9.679088 7,784.109
S&P 500 –30.87081 –0.216854 10.47676 9,762.004
NIKKEI –29.64148 –0.299980 9.307411 6,986.622
Notes: † ADF Test Statistic is estimated by fitting the equation in the form:
Dyt = j + dyt–1 + S4j = 1 qj Dyt–j + mt;
N−k 2 1
§ Jarque Bera Test Statistic ( JB )= [ s + (K − 3)2 ] where N = number of observations,
6 4
S = coefficient of skewness, K = coefficient of kurtosis, k = number of estimated coefficients used to create the series
and JB follows the Chi-square distribution with 2 d. f.

compared to normal distribution. These observed skewness and kurtosis values indicate that the
distribution of daily return series of all the selected indices is non-normal. The JB normality test also
supports this non-normality of return distributions as we find from Table 1 that the estimated values
of JB statistic of all the return series are statistically significant at 1 per cent level. This corroborates
the findings of the earlier studies in this field.
As part of the diagnostic checking, the visual inspection of the plot of daily return series of S&P CNX
Nifty as shown in Figure 1 reveals that returns continuously fluctuate around a mean value that is close
to zero. The movements are in both positive and negative territories and large fluctuations tend to cluster
together separated by periods of relatively low fluctuations showing volatility clustering.
The LM test is applied for determination of presence of “ARCH effect” in the residual of the estimated
model, the result of which is presented in Table 2. From Table 2, we find that both the F-statistic and the
ARCH—LM statistic are statistically significant at 1 per cent level for Nifty thereby rejecting the null
hypothesis of no heteroskedasticity. The result of the ARCH–LM test confirms the presence of ARCH
effect in Nifty return series which is also consistent with the graphical presentation of the return series
showing volatility clustering.
Mean and standard deviations of Nifty index return are presented in Table 3. The mean return on the
Nifty is 0.039 per cent per day and standard deviation is 1.65 per cent per day. We divide the sample
period into pre- and post-futures, pre- and post-options, pre and post-currency futures and pre and post-
interest rate futures periods to observe the changes in mean and standard deviations of daily Nifty return
which are also presented in Table 3. The mean daily return on the nifty is 0.034 per cent in pre-futures
period with a standard deviation of 1.78 per cent per day and 0.041 per cent in post futures period with
a standard deviation of 1.61 per cent per day. In the pre-option period, the mean Nifty return is 0.010 per
cent with a standard deviation of 1.76 per cent per day and in the post-option period the mean Nifty
return is 0.054 per cent with a standard deviation of 1.60 per cent per day. So standard deviation in daily
Nifty return has declined in post-futures/options period, whereas in the pre-currency futures period mean
Nifty return is 0.044 per cent with a standard deviation of 1.62 per cent per day and in the post-currency
futures period the mean Nifty return is 0.024 per cent with a standard deviation of nearly 1.8 per cent per
day implying an increase in standard deviation in daily Nifty return. But in the pre-FUTINT period,
mean Nifty return is 0.044 per cent with a standard deviation of 1.73 per cent per day and those in the

Paradigm, 18, 2 (2014): 135–153

 03/30/12
01/06/12
10/12/11
07/18/11
04/20/11
01/24/11
10/28/10
08/02/10
05/06/10
02/08/10
11/11/09
08/18/09
05/22/09
02/24/09
11/27/08
09/02/08
06/06/08
03/10/08
12/12/07
09/17/07
06/21/07
Return in S&P CNX Nifty from 01-04-1996 to 31-03-2012

03/26/07
12/26/06
09/29/06
07/05/06
04/11/06
01/13/06
10/20/05
07/25/05
04/29/05
02/01/05
11/05/04
08/12/04
05/18/04

Date
02/19/04
11/24/03
09/01/03
06/05/03
03/10/03
12/11/02

Figure 1. Return in S&P Nifty from 1 April 1996 to 31 March 2012

09/16/02
06/20/02
03/25/02
12/27/01
10/01/01
07/05/01
04/09/01
01/11/01
10/16/00
07/20/00
04/25/00
01/27/00
11/02/99
08/05/99
05/11/99
02/12/99
11/19/98
08/25/98
05/29/98
03/04/98
12/05/97
09/10/97
06/13/97
03/18/97
12/19/96
09/24/96
06/28/96
04/02/96
0.2000

0.1000

0.0000

–0.1000

Return in S&P CNX Nifty

Impact of Introducing Different Financial Derivative Instruments in India 147

Table 2. Result of the ARCH–LM Test on Return Series of S&P CNX Nifty

Index F-Statistic Prob. F ARCH LM Statistic © Prob. Chi-square

S&P CNX Nifty 170.2464 0.000000 163.6515 0.000000
Notes: © ARCH LM Statistic (at lag-1) is the LM test statistic for examining the presence of ARCH effect in the residuals of the
estimated model. If the value of ARCH LM Statistic is greater than the critical value from the Chi-square distribution,
the null hypothesis of no heteroskedasticity is rejected.

Table 3. Means and Standard Deviations of Daily Nifty Return, 1 April 1996 to 31 March 2012

Nifty Standard
Period NOB Nifty Mean Deviations
1 April 1996 to 31 March 2012 4177 0.000398 0.016566
Pre-Futures 1096 0.000347 0.017855
Post-Futures 3081 0.000416 0.016085
Pre-Options 1350 0.000100 0.017661
Post-Options 2827 0.000541 0.016018
Pre-Currency Futures 3241 0.000443 0.016212
Post-Currency Futures 936 0.000244 0.017746
Pre- FUTINT in Currency Derivative Segment 3500 0.000439 0.017364
Post- FUTINT in Currency Derivative Segment 677 0.000188 0.011598
Notes: Futures contracts were introduced on 12 June 2000.
Options contracts were introduced on 4 June 2001.
Currency Futures contracts were introduced on 29 August 2008.
FUTINT in Currency Derivative Segment were introduced on 31 August 2009.

post-interest rate futures period are, respectively, 0.019 per cent and 1.16 per cent per day implying a
decline in standard deviation in daily Nifty return again.
The results of the fitted GARCH (1, 1) model (Equation 7) to daily Nifty return series are presented
in Table 4. All the coefficients in the mean and variance equations are found to be significant at 1 per cent
level except lag return in Nikkei which is, however, significant at 10 per cent level. Significant F-statistic
implies that there is heteroscedasticity in return variance. So there is return volatility throughout the
period. Further, (a1 + b1) < 1 implies that there is no unit root and the series concerned is stationary.
Hence, GARCH (1, 1) gives us good fit to the daily Nifty return series. Both a1 and b1 are highly
statistically significant. The sum of a1 & b1 is very close to unity (0.98 approximately) implying shocks
to the conditional variance is highly persistent.
Therefore, there is no sufficient statistical reason of rejecting hypothesis 1.
The results of the estimation for the impact of futures introduction (Equation 8) on Nifty volatility are
presented in Table 5. The coefficient of the futures dummy g1 is significantly (significant at 1 per cent
level) different from zero indicating that introduction of futures trading does have impact on volatility of
Nifty return. Further, the negative sign of the dummy coefficient implies that volatility has declined after
futures’ introduction.

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148 Suparna Nandy (Pal) and Arup Kr. Chattopadhyay

Table 4. Maximum Likelihood Estimates of GARCH (1, 1) Model of Return Series of S&P CNX Nifty
Rt, Nif = a0 + a1 Rt–1,Nif + a2Rt–1, SP + a3Rt–1, NIK + et  et ~N(0, ht)
ht = a0 + a1 e2t–1 + b1 ht–1

Coefficient Symbol Estimates Z Statistic Probability

Intercept a0 0.000906* 4.452169 0.0000
Lag Nifty Return a1 0.058614* 3.617446 0.0003
Lag S&P 500 Return a2 0.190501* 12.62181 0.0000
Lag NIKKEI Return a3 –0.027143*** –1.901048 0.0573
Arch 0 a0 6.31E-06* 9.652114 0.0000
Arch 1 a1 0.110781* 18.90554 0.0000
Garch 1 b1 0.870683* 150.9909 0.0000
Notes: R2 = 0.028659 → coefficient of GARCH model determination;
F-Statistic = 20.50583*, Prob. (F-Statistic) = 0.000000.
(*), (**), (***) indicate significance of the parameter at 1%, 5%, 10% levels respectively.

Table 5. Maximum Likelihood Estimates of GARCH (1, 1) Model of Return Series of S&P CNX Nifty with
Futures Dummy
Rt,Nif = a0 + a1 Rt–1,Nif + a2 Rt–1,SP + a3 Rt–1, NIK + et  et~N (0, ht)
ht = a0 + a1 e2t–1 + b1 ht–1 + g1 Df

Coefficient Symbol Estimates Z Statistic Probability

Intercept a0 0.001091* 5.727858 0.0000
Lag Nifty Return a1 0.052291* 3.226581 0.0013
Lag S&P 500 Return a2 0.200349* 13.77967 0.0000
Lag NIKKEI Return a3 –0.023442*** –1.796028 0.0725
Arch 0 a0 2.87E-05* 9.440266 0.0000
Arch 1 a1 0.144713* 17.96929 0.0000
Garch 1 b1 0.788450* 70.65552 0.0000
Futures Dummy g1 –1.68E-05* –8.099096 0.0000
Notes: R2 = 0.028144 → coefficient of GARCH model determination;
F-Statistic = 17.24706*, Prob. (F-Statistic) = 0.000000.
(*), (**), (***) indicate significance of the parameter at 1%, 5%, 10% levels respectively.

Table 6 represents the results of the estimation for the impact of options introduction in the presence
of trading in futures (Equation 11). We find that the coefficient of the options dummy g2, though negative,
is not significantly different from zero but the futures dummy coefficient g1, is still significantly
(significant at 1 per cent level) different from zero. It establishes that introduction of the options contract
has no additional impact on stock market volatility over and above the impact of futures’ introduction.
The results of the estimation for assessing the impact of introduction of currency futures in the presence
of futures and options contracts (Equation 12) are represented in Table 7. From the table, we find that the
coefficient of the currency futures dummy g3 is significantly (significant at 5 per cent level) different from

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Impact of Introducing Different Financial Derivative Instruments in India 149

Table 6. Maximum Likelihood Estimates of GARCH (1, 1) Model of Return Series of S&P CNX Nifty with
Futures and Options Dummy together
Rt,Nif = a0 + a1 Rt–1,Nif + a2 Rt–1, SP + a3 Rt–1, NIK + et  et~N(0, ht)
ht = a0 + a1 e2t–1 + b1 ht–1 + g1 Df + g2Do

Coefficient Symbol Estimates Z Statistic Probability

Intercept a0 0.000932* 6.058431 0.0000
Lag Nifty Return a1 0.037167* 2.732813 0.0063
Lag S&P 500 Return a2 0.215777* 19.19988 0.0000
Lag NIKKEI Return a3 –0.030089* –2.903628 0.0037
Arch 0 a0 5.15E-05* 14.25311 0.0000
Arch 1 a1 0.164727* 21.20515 0.0000
Garch 1 b1 0.682522* 49.60090 0.0000
Futures Dummy g1 –2.83E-05* –6.338990 0.0000
Options Dummy g2 –4.03E-06 –1.207033 0.2274
Notes: R2 = 0.029548 → coefficient of GARCH model determination;
F-Statistic = 15.86297*, Prob. (F-Statistic) = 0.000000.
(*), (**), (***) indicate significance of the parameter at 1%, 5%, 10% levels respectively.

Table 7. Maximum Likelihood Estimates of GARCH (1, 1) Model of Return Series of S&P CNX Nifty with
Dummy for Futures, Options and Currency Futures Contract together
Rt,Nif = a0 + a1 Rt–1,Nif + a2 Rt–1, SP + a3 Rt–1, NIK + et  et~N(0, ht)
ht = a0 + a1 e2t–1 + b1 ht–1 + g1 Df + g2 Do + g3 Dcd

Coefficient Symbol Estimates Z Statistic Probability

Intercept a0 0.001006* 5.009482 0.0000
Lag Nifty Return a1 0.054387* 3.234978 0.0012
Lag S&P 500 Return a2 0.204674* 13.73696 0.0000
Lag NIKKEI Return a3 –0.023170*** –1.715765 0.0862
Arch 0 a0 3.82E-05* 10.19137 0.0000
Arch 1 a1 0.161012* 16.46722 0.0000
Garch 1 b1 0.751045* 51.80444 0.0000
Futures Dummy g1 –1.27E-05** –2.422331 0.0154
Options Dummy g2 –1.02E-05** –2.138835 0.0324
Currency Futures Dummy g3 3.95E-06** 2.161623 0.0306
Notes: R2 = 0.028538 → coefficient of GARCH model determination;
F-Statistic = 13.60109*, Prob. (F-Statistic) = 0.000000.
(*), (**), (***) indicate significance of the parameter at 1%, 5%, 10% levels, respectively.

zero and positive, indicating that introduction of currency futures has led to further increase in the stock
market volatility in presence of trading in futures and options contract. Moreover, the coefficients of futures
dummy g1 is still significantly (significant at 5 per cent level) different from zero and negative but to

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150 Suparna Nandy (Pal) and Arup Kr. Chattopadhyay

mention that coefficient of the options dummy g2 now becomes significant (significant at 5 per cent level)
and negative. From this observation it seems to us that the insignificant impact of options introduction
while estimating Equation 11 and presented in Table 6 was due to not considering presence of trading in
currency futures contract. Therefore, when we incorporate trading in currency futures contract in our
estimation, the impact of options introduction on the stock market volatility has become significantly
negative, that is, options trading has actually a declining impact on the stock market volatility.
In Table 8, the results of the estimation for examining the impact of introduction of interest rate futures
along with the presence of trading in equity derivatives (futures & options together) and currency
futures (in terms of Equation 13) are presented. We find that the estimated coefficient of interest rate
futures dummy g3 is significantly (significant at 1 per cent level) different from zero and negative,
indicating that introduction of FUTINT in the Currency Derivative segment has reduced the stock market
volatility in presence of other derivatives. Here also the estimated coefficient of equity derivative dummy
g1 (significant at 1 per cent level) is negative and that of Currency Futures dummy g2 (significant at 1 per
cent level) is positive and still significantly different from zero. Thus, hypotheses 2 and 3 both are accepted.

Table 8. Maximum Likelihood Estimates of GARCH (1, 1) Model of Return Series of S&P CNX Nifty with
Dummy for Equity Derivatives (Futures & Options together), Currency Futures Contract and Interest Rate
Futures Contract for the Whole Period of Study
Rt,Nif = a0 + a1 Rt–1,Nif + a2 Rt–1, SP + a3 Rt–1, NIK + et  et~N(0, ht)
ht = a0 + a1 e2t–1 + b1 ht–1 + g1 Ded + g2Dcd + g3 Dird

Coefficient Symbol Estimates Z Statistic Probability

Intercept a0 0.000932* 4.567074 0.0000
Lag Nifty Return a1 0.057562* 3.339369 0.0008
Lag S&P 500 Return a2 0.186646* 11.53565 0.0000
Lag NIKKEI Return a3 –0.026798*** –1.845643 0.0649
Arch 0 a0 2.24E-05* 9.262938 0.0000
Arch 1 a1 0.112391* 16.50875 0.0000
Garch 1 b1 0.829272* 84.97831 0.0000
Equity Derivative Dummy g1 –1.24E-05* –7.253467 0.0000
Currency Futures Dummy g2 4.49E-05* 7.339201 0.0000
Interest Rate Futures Dummy g3 –4.53E-05* –7.282241 0.0000
Null hypothesis Wald Test Statistic‡ Probability Chi-square
(1) H0 : g1 = g2 65.34596 0.000000
(2) H0 : g2 = g3 53.93854 0.000000
Notes: R = 0.028484 → coefficient of GARCH model determination;
2

F-Statistic = 13.57472*, Prob. (F-Statistic) = 0.000000.

‡ The Wald statistic here tests firstly, the null hypothesis that whether Equity Derivative dummy coefficient g1 is equal
to the currency futures dummy coefficient g2 and secondly, dummy coefficient of currency futures contracts g2 is equal
to the dummy coefficient of FUTINT in Currency Derivative segmentin g3 Equation (13). It is a chi-square test in
which the null hypothesis is rejected if the calculated value of test statistic is found to be greater than the chi-square
value in the table.
(*), (**), (***) indicate significance of the parameter at 1%, 5%, 10% levels, respectively.

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Impact of Introducing Different Financial Derivative Instruments in India 151

Therefore, introduction of equity derivatives in the forms of stock index futures and stock index
options and FUTINT in the currency derivative segment have found to be successful in reducing the
stock market volatility in India whereas introduction of currency futures contracts have a destabilizing
impact on the stock market volatility in India. Moreover from Table 8, we observe that the absolute
magnitude of the estimated value of currency futures dummy coefficient (g2) is greater than equity
derivative dummy coefficient (g1) and that of FUTINT dummy (g3) is greater than currency futures
dummy (g2). For determining whether any perceived differences in estimated coefficients are actually
statistically significant or not, the Wald statistic has been employed where the two null hypotheses which
to be tested are (1) H0 : g1 = g2 and (2) H0 : g2 = g3. The observed values of the Wald statistic for both null
hypotheses (1) and (2) are found to be statistically significant at 1 per cent level. Thus, both the hypotheses
of equality of coefficients are rejected. Therefore, we can conclude that the effect on volatility is more
statistically significant following the introduction of both trading in equity derivatives (futures and
options) and currency futures contracts compared to the effect of introduction of equity derivative
contracts only. This implies that though the introduction of equity derivative contracts in the forms of
stock index futures and stock index options has been successful in reducing the stock market volatility
in India, the introduction of currency futures in the currency derivative segment has a more destabilizing
impact on the stock market volatility. The empirical finding of grater variance of daily INR/USD exchange
rate in the post-currency future introduction period (which was calculated to be 4.967) compared to the
pre-currency futures introduction period (which was calculated to be 4.623) also supports this statistical
observation of ineffectiveness of currency futures in stabilizing the Indian stock market. Further, the
volatility of Nifty has decreased more after the introduction of FUTINT in the currency derivative
segment compared to increase in volatility after the introduction of currency futures contracts in currency
derivative segment, implying thereby that the interest rate futures contract has more stabilizing impact
than the destabilizing impact of currency futures on stock market volatility in India.

Concluding Remarks
Impact of the introduction of trading in derivative contracts in the forms of stock index futures, stock
index options, currency futures and interest rate futures in India on the underlying stock market volatility
has been examined here using data on daily closing prices of S&P CNX Nifty in a GARCH (1, 1)
framework capturing heteroscedasticity in stock market return. Our estimation period spans from
1 April 1996 to 31 March 2012, covering quite a long period before and after introduction of derivatives
in the country. The results of the study suggest that there is a time-varying persistence of volatility in
the Indian stock market throughout the estimation period. Introduction of equity derivatives in the
forms of stock index futures and stock index options and also interest rate futures (in currency derivative
segment) have found to be successful in reducing the stock market volatility in India, whereas
introduction of currency futures has a destabilizing impact on the stock market volatility in the country.
We also observe here that the destabilizing impact of the currency futures is stronger than the stabilizing
impact of equity derivatives on the stock market volatility in the country. Further, it is found that the
stock market volatility has declined more after the introduction of interest rate futures compared with
its increase after the introduction of currency futures. The probable reasons behind the findings of the
study are that (i) the derivative instruments are introduced on the general expectation of controlling

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152 Suparna Nandy (Pal) and Arup Kr. Chattopadhyay

risk, hence volatility in the underlying spot market, which happened in the cases of equity derivatives;
(ii) same happens in case of interest rate derivative because this instrument facilitates to establish
stabilization in interest rates, hence stock prices as the latter depends both theoretically and empirically
on the former; (iii) but the ineffectiveness of currency futures in stabilizing the stock prices might
happen due to (a) excessive involvement of speculators in the foreign exchange market and (b) current
integration of the Indian economy with the rest of the world leading to close dependence of stock prices
and foreign exchange rates.
The policy implications of these findings are that (i) more and more derivative instruments on different
stock/stock index related underlyings are to be introduced, which will lead to establish stability and
efficiency in the Indian stock market and (ii) all-round efforts are to be made to check the excessive
speculative activities in the foreign exchange market because currency futures alone could not
successfully stabilize the foreign exchange market and thereby, the stock market. As a policy measure
government may undertake further reforms in the domestic stock market (in the forms of introducing
sophisticated financial instruments) as well as in the foreign currency market (in the line of stabilizing
portfolio investment by FIIs) or intervene systematically and periodically in the foreign exchange market
(to reduce wide short-term volatility in the foreign exchange market) all of which have direct bearing on
the vibrancy of the Indian stock market.
However, the study has not considered high-frequency data for the volatility analysis and the
conclusions are based only on the analysis of NSE stock index Nifty. As a future scope of research one
may also examine the asymmetric nature of volatility inter-linkages among the stock market, money
market and the foreign exchange market in India using the multivariate E-GARCH model with
disaggregated data.

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