Hidden in Plain Sight The Impact of Stoc

HIDDEN IN PLAIN SIGHT: THE IMPACT OF STOCK INDEX
FUTURES TRADING ON SPOT MARKET VOLATILITY OF

SOUTHEAST AND EAST ASIAN ECONOMIES
An Undergraduate Thesis
Presented to the
Faculty of Financial Management Department
Ramon V. del Rosario College of Business
De La Salle University
In Partial Fulfillment of the

Course Requirements for the
Degree in Bachelor of Science in
Management of Financial Institutions
Term 3, A.Y. 2015-2016
Campos, Michael Anthony S.

Capule, Ryan Ray F.
Casco, Jillian Jovel Marie J.
Chuaunsu, Dominic Rainier M.
August 2016
ACKNOWLEDGEMENTS
Undertaking this undergraduate thesis has been truly a worthwhile experience, and it
would not have been possible to do it without the support and guidance we have received
from the special people involved in this study.
To Almighty God, You are the Alpha and the Omega. To the very end of this
work, you have fought along with us. No words could express the gratitude we feel.
To Mr. Andy Umali, thank you very much for your encouragement, guidance, and
patience throughout the entire process. We are extremely grateful for all the technical and
practical advice you have given. Your unwavering support has emboldened us to excel.
To our esteemed panelists, Ms. Kristine Mae Lagdameo, Mr. Steven Lim, and Mr.
Enrico Amat, the insightful suggestions and constructive feedback you have given us
have definitely led to a better work and, for that, we are truly grateful.
To Dr. Neriza Delfino, your sensible opinion and advice during our thesis
proposal has been valuable to us. Thank you for sharing your knowledge and wisdom to
us. Without your guidance in the beginning, this study would not have been created. Our
thanks also go out to Ms. Catherine Almonte for the valuable comments that improved
our proposal.
To the different professionals, Mr. Marc Bautista, Head of Research at Metrobank,

Mr. Tommy Chua, Global Banking and Finance Head at Société Générale, and Mr. Hank
Bessembinder, Chair, W.P. Carey School of Business, Arizona State University, who have
graciously given us time to consult with them and for providing us guidance to our study.
To Bloomberg Philippines and Philippine National Bank, for giving us the elusive
opportunity to gather all the financial data we needed for the completion of this study.
To our family, for their continuous training and undying support they have shared.
Our deepest gratitude and love for your dedication and for your encouragement during
our undergraduate studies that provided foundation for this work. We will forever be
indebted.
ABSTRACT
With the recent ASEAN economic integration and the advancement of the credit
rating in the Philippines, the Philippine economy is now more globally competitive,
which also means that it is more exposed to higher financial risks. Yet, the Philippine
financial system still lags behind other Asian countries. While the lack of financial
complexity has hindered some investors, it may have also shielded the Philippine
economy from the brunt of the Global Financial Crisis of 2007-2009. As such, the
researchers of this study attempt to see if complex financial products, specifically index
futures, provide tangible benefits to the overall financial market of its domestic economy,
or if it just provides sophisticated investors opportunities to make speculative and
arbitrage profits. By using the GARCH as well as the ARIMA model, they found that
futures trading in the Asian region exhibits a destabilizing or negligible effect, with the
exception of Hong Kong and Shanghai. It was also found that the Philippine market has
a long-run relationship with all the markets in the Asian region covered in this study.
Thus, the researchers provide a stable foundation upon which policymakers, experts in
the financial industry, and academe can sustainably improve the stability of markets
within the Asian region especially the Philippines.
Keywords: GARCH Model, Index Futures, Spot Market Volatility, Derivatives
JEL Classification: G10, G14, O16
TABLE OF CONTENTS
ABSTRACT ..................................................................................................................... 5
CHAPTER 1: INTRODUCTION ...................................................................................

8 1.1. Background of the Research Problem .............................................................. 9
1.2. Statement of the Research Problem ............................................................... 10
1.3. Objectives of the Study ................................................................................... 11
1.4. Statement of Hypotheses ................................................................................ 12
1.5. Significance of the Study ................................................................................ 17
1.5.1. For Financial Institutions ..................................................................... 17 1.5.2.
For Institutional and Retail Investors ................................................... 18 1.5.3. For
Speculators ..................................................................................... 19 1.5.4. For
Financial Policymakers and Regulatory Bodies ............................ 20 1.6. Scope and
Limitations ..................................................................................... 21
CHAPTER 2: REVIEW OF RELATED LITERATURE .......................................... 23

2.1. The Derivatives Market in the ASEAN Region ............................................. 23
2.2. ASEAN Stock Market Cointegration ............................................................. 25
2.3. Derivatives Mitigating Spot Market Volatility .............................................. 28
2.4. Derivatives Inducing Spot Market Volatility ................................................. 32
2.5. Derivatives Showing Unchanged and Mixed Effects on Spot Volatility ........ 33
2.6. Synthesis and Research Gap .......................................................................... 38
2.7. Literature Map ................................................................................................ 40
CHAPTER 3: FRAMEWORKS ...................................................................................

41 3.1. Theoretical Framework .................................................................................. 41
3.1.1. Efficient Market Hypothesis ................................................................ 41 3.1.2.
Stabilization and Destabilization Hypothesis ....................................... 43 3.1.3.
Theories on Futures Trading ................................................................ 45 3.1.4.
Arbitrage Pricing Theory ..................................................................... 46 3.2.
Conceptual Framwork .................................................................................... 47 3.3.
Operational Framework .................................................................................. 49
CHAPTER 4: RESEARCH METHODOLOGY .........................................................

52 4.1. Decision Tree Map ......................................................................................... 52
4.2. Data Description and Collection Method ....................................................... 53
4.3. Estimation Procedure ..................................................................................... 56
4.3.1. The Conditional Volatility Models ...................................................... 58 4.3.2.
ARCH Model ....................................................................................... 59
4.3.3. Volatility Effect of Futures Introduction through GARCH Models .... 59 4.3.4.
Impact of Futures Trading Activity ...................................................... 63 4.3.5.
Johansen Multivariate Cointegration Test ........................................... 66
CHAPTER 5: PRESENTATION AND ANALYSIS OF RESULTS ........................ 69

5.1. Volatility Effects of Futures Introduction through GARCH Model .............. 70
5.1.1. Descriptive Statistics ............................................................................ 70 5.1.2.
Diagnostic Testing for GARCH Models .............................................. 71 5.1.3.
Analysis of GARCH Model with Dummy Variable ............................ 71 5.2. Impact
of Futures Trading Activity ................................................................ 87 5.2.1.
Descriptive Statistics ............................................................................ 87 5.2.2.
Decomposition using ARIMA Model .................................................. 88 5.2.3.
Assessing the Effect of Futures Trading Components on Volatility .... 92 5.2.4.
Summary of Decomposition Findings ............................................... 100 5.3.
Cointegration of the Philippine Financial Market with Asian Markets ....... 102 5.4.
Synthesis of Results and Closing the Gap .................................................... 106
CHAPTER 6: CONCLUSION AND RECOMMENDATIONS ............................. 108

6.1. Conclusion .................................................................................................... 108
6.2. Recommendations ........................................................................................ 110
BIBLIOGRAPHY ....................................................................................................... 113
APPENDICES ............................................................................................................. 121

APPENDIX 1. Empirical Testing for Volatility Effects of Futures Inception .. 121 1.1.
Unit Root Test using Augmented-Dicky Fuller ..................................... 121 1.2. Test
for Optimal Lag Structure ............................................................. 123 1.3. Lagrange
Multiplier (LM) Test for ARCH Effects ............................... 126 1.4. GARCH Model
Results using Dummy Variable Approach ................. 129 1.5. Post-Estimation
Checking ..................................................................... 141 APPENDIX 2. Empirical
Testing for the Impact of Futures Trading Activity ... 143 2.1. GARCH Model Results
for Decomposition Findings ........................... 143 2.2. Post-Estimation Checking
..................................................................... 147 APPENDIX 3. Johansen Multivariate
Cointegration Test .................................. 149 3.1. Unit Root Test using
Augmented-Dicky Fuller ..................................... 149 3.2. Summary Results of Unit
Root Test ..................................................... 152 3.3. Johansen Multivaiate
Cointegration Test Results ................................. 152 3.4. Post-Estimation Checking
..................................................................... 153
CHAPTER 1
INTRODUCTION
1.1. Background of the Research Problem
Over the past decades, derivatives markets have played an increasing role within
the financial world. Accumulating exchange trades (ETD) and over-the-counter (OTC)
market transactions are becoming more popular in emerging and advanced economies.
With this increasing role in global finance, the market effects of derivatives are becoming
increasingly important. Derivatives can be defined as financial assets whose values are
derived from other underlying financial variables such as index level, commodity price,
interest or exchange rate (Hull, 2012). While there are many types of derivatives, they can
generally be categorized into an exchange-traded (ETD) security, which are standardized
and are traded on a formalized exchange, or an over-the-counter (OTC) security, which
are custom-tailored to the parties (Fratzscher, 2006).
Futures and options are dynamically traded on exchanges, while forward contracts
and swaps are consistently traded on OTC markets. In theory, financial derivatives are
useful for managing or shifting risks, thereby eliminating the risk held by a particular
investor. However, due to its structure as a tradable financial security, it can also be used
by speculators and arbitrageurs for making quick profits. Futures contracts are a type of
financial derivative wherein a future financial transaction is agreed upon today; this helps
mitigate possible price risks, as the parties that entered into the contract are “locked in”.
However, as the underlying security’s market value can fluctuate, this gives the futures
contract a nominal value, which fluctuates along with the underlying security as well as
external market influences. Financial markets around the world have embraced this
product, with every major financial market having at least one derivatives exchange. In
the mid-1980s, the Philippines attempted to introduce a futures exchange into the market;
although, it was soon closed due to issues of fraud (Philippines Securities and Exchange
Commission, n.d.).
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As home of some of the fastest developing economies in the world, Asia built its
way to a more assertive financial derivatives market. In 2006, South Korea had the
highest volume of derivatives trades; whereas, India has the fastest growing derivatives
exchange worldwide (Fratzscher, 2006). A report from World Bank specified that
derivatives market in Asia comprised thirty percent of the world foreign exchange and
that Asian derivative markets are gradually shifting from Over-The-Counter (OTC)
Derivatives to Exchange
Traded Derivatives (ETD) (Fratzscher, 2006). According to Hohensee and Lee (2006),
ETDs provide no credit exposure, as settlement is guaranteed, along with lower
transaction costs and lesser information asymmetry compared to OTCs, thereby
providing more transparency and efficiency to hedgers. However, the Philippine financial
sector has been resistant to this trend, with all derivatives within the Philippines
remaining as custom
made OTC derivatives, such as swaps, among others.
With the Philippines being one of the emerging economies in Southeast Asia, the
country has engaged in derivatives trading, particularly in forward contracts and swaps
during the early 1980s, as mentioned earlier. The Manila International Future Exchange
(MIFE) was launched in 1985 and offered sugar, soybean, copra, coffee futures, among
others. However, according to the Securities and Exchange Commission (SEC), they
closed it down indefinitely in 1997 due to issues of fraud committed by some government
officials and brokers. Over time, the Philippine economic system has improved, with
Standard & Poor’s (S&P) confirming Philippines’ BBB stable credit rating as well as the
sustained income growth, indicating that the country’s economy has become even more
globally competitive and relatively attractive to investments (Venzon, 2015). Despite all
of these financial advancements and globalization occurring, it exposes the economy and
financial system of the Philippines and other Asian countries to greater risk levels. Thus,
prudent financial regulation to promote stability becomes even more imperative.
9
1.2. Statement of the Research Problem
Many financial market analysts and members of the academe have suggested that
the introduction of financial derivatives have been beneficial in creating an efficient
portfolio, as investors can use them to hedge risks. However, a number of economists and
policy-makers see these as a threat to financial stability, as derivatives are extremely
difficult to regulate due to their complexity. This can empower sophisticated investors and
allow them to manipulate the market or engineer a disastrous market meltdown, much
like the sub-prime mortgage crisis of 2007. Nonetheless, financial markets across the
globe have been adopting these products in increasing numbers. Thus, these changes
have caught the attention of researchers and academicians globally.
One of the greatest risks that investors face would be the risk of large security
price changes, or the price risk. As a futures contract can help control the price risk faced
by an investor, a collective market of the products can theoretically reduce the price risk
faced by all market participants by reducing price volatility. Several studies into this
theory have reached different conclusions and an agreement has yet to be made. For
instance, certain studies show that an organized futures exchange lessens spot market
volatility, strengthens liquidity, as well as promotes market efficiency, thereby inherently
proposing stabilization measures (Kasman & Kasman, 2007; Nair, 2008; Sakthiviel &
Kamaiah, 2011; Matanovic & Wagner, 2012; Bohl, Diesteldorf, & Siklos, 2014). On the
other hand, some studies have concluded that the presence of futures exchange does
induce spot market volatility, supporting the destabilization hypothesis (Chang, Cheng &
Pinegar, 1999; Kang & Yoon, 2007). Meanwhile, other researchers have found mixed
effects or no effect at all (Gulen & Mayhew, 2001; Pilar & Rafael, 2002;
Malikkarjunappa & Afsal, 2008). Given these conflicting findings and lack of stylized
fact, the researchers aim to find which of these schools of thought apply to the Asian
region, and then extend it to the Philippine market.
The ASEAN markets have liberalized most of its financial markets in the last two
decades to enable faster economic growth. Although the level of financial liberalization
10
and maturity varies among ASEAN countries, there appears to be a long-run equilibrium
relationship among their financial markets (Janor & Ali, 2007). Because of the varying
conditions within each financial market, this study also aims to test for the cointegration
among Southeast Asia’s equity markets so as to verify if their findings are still applicable
today. By doing so, this will aid the researchers in drawing inferences with regard to the
feasibility of introducing an organized futures exchange within the Philippines. An equity
market that is cointegrated with that of other Asian countries, such as Malaysia,
Indonesia, Singapore, Thailand, South Korea, Japan, and China, will indicate that the
markets move together in the long-run. Thus, the researchers seek answers to the
research questions: Do futures exchanges within the region have a significant effect on
spot market volatility? If so, what is this effect – does it mitigate or induce spot market
volatility? Finally, does the Philippine equity market have any market similarities which
may indicate the effects of such an exchange locally?
1.3. Objectives of the Study
Testing for the effects of a futures exchange on the volatility of the respective
stock indices of the ASEAN-5 plus 3 economies would enable the researchers to
empirically determine the effects of an organized futures exchange on the Philippine
financial system. Some previous studies have shown that futures exchanges have
stabilizing effects on equity indices and other financial markets, as it has beneficial
effects to liquidity as well as market efficiency (Bessembinder & Seguin, 1992; Parchure,
2003; Kasman & Kasman, 2007; Sakthiviel & Kamaiah, 2011; Matanovic & Wagner,
2012; Moses, 2013; Bohl et al., 2015). Moreover, a financial system that allows the use
of derivatives for trading securities not only benefits stock indices of an exchange, but
also financial institutions as well as retail and institutional investors. However, other
studies such as that of Chang et al. (1999) claim that the use of derivatives, more
specifically futures, increase the spot volatility of the stocks comprising the stock index
in question; other studies also indicate
11
that a derivatives market induces volatility as explained by the destabilization hypothesis
(Chang et al., 1999; Kang & Yoon, 2007; Alan, Karakozoglu, & Kormaz, 2015). Hence,
given the inconclusive results that previous studies have shown, the researchers aim to
achieve the following objectives:
1. To determine the impact of the establishment of a futures exchange and futures

trading activity on the volatility of the underlying equity markets in Southeast
and East Asian economies.
2. To assess the long-run relationship of the Philippine equity market with its
regional counterparts, which may link these results to the Philippine market.
3. To provide possible implications of the effects of the establishment of futures

exchanges and futures trading on spot market volatility.
1.4. Statement of Hypotheses
To guide the researchers with the concepts, which must be proven, a statement of
hypotheses must be provided. First, there is the null hypothesis (H0), which would
indicate the status quo. This statement would indicate that there is no significant
relationship, or that there is no significant deviation from the current market condition.
Next, there are alternative hypotheses (HA), which would lay contrary claims to the null
hypothesis. Moreover, empirical tests will attempt to indicate the true relationship of the
variables being examined, as well if the results are statistically significant. Careful
selection of the empirical model, as well as thorough investigation, through the use of
post-estimation statistical testing, is required to avoid the occurrence of Type I and Type
II errors, wherein the null hypothesis is erroneously rejected, and a null hypothesis is
erroneously accepted, respectively. Furthermore, both errors have grave consequences;
thus, the researchers will make every reasonable effort to avoid them. To better organize
the hypotheses, they will
12
be clustered according to theory, and by economy. As such, the hypotheses that will guide
the researchers are as follows:
A. Relationship between the presence of a futures exchange and the volatility

of the underlying market.
1. Singapore
▪ H0: There is no statistically significant relationship
between the presence of an organized derivatives market
and underlying market volatility within Singapore.
▪ H1: There is a statistically significant relationship
and underlying market volatility in Singapore.
2. Malaysia
and underlying market volatility within Malaysia.
and underlying market volatility in Malaysia.
3. Indonesia
and underlying market volatility within Indonesia.
and underlying market volatility in Indonesia.
13
4. Thailand
∙ H0: There is no statistically significant relationship between
the presence of an organized derivatives market and
underlying market volatility within Thailand.
∙ H1: There is a statistically significant relationship between
underlying market volatility in Thailand
5. China (Hong Kong)
▪ H0: There is no statistically significant relationship between
underlying market volatility within China (Hong Kong).
between the presence of an organized derivatives market and
underlying market volatility in China (Hong Kong). 6. China
(Shanghai)
and underlying market volatility within China (Shanghai).
and underlying market volatility in China (Shanghai).
7. Japan
and underlying market volatility within Japan.
14
and underlying market volatility in Japan.
8. South Korea
and underlying market volatility within South Korea.
and underlying market volatility in South Korea.
B. The relationship between the equity market of countries within the study and
that of the Philippines.
1. Singapore
▪ H0: Singaporean equity markets do not share a long-run
equilibrium relationship with equity markets of the
Philippines
▪ H1: Singaporean equity markets do share a long-run
Philippines.
2. Malaysia
▪ H0: Malaysian equity markets do not share a long-run
Philippines
▪ H1: Malaysian equity markets do share a long-run
Philippines.
15
3. Indonesia
▪ H0: Indonesian equity markets do not share a long-run
Philippines
▪ H1: Indonesian equity markets do share a long-run
Philippines.
4. Thailand
∙ H0: Thai equity markets do not share a long-run
Philippines
∙ H1: Thai equity markets do share a long-run equilibrium
relationship with equity markets of the Philippines.
5. China (Hong Kong)
▪ H0: Chinese (Hong Kong) equity markets do not share a
long-run equilibrium relationship with equity markets of
the Philippines
▪ H1: Chinese (Hong Kong) equity markets do share a long
run equilibrium relationship with equity markets of the
Philippines.
6. China (Shanghai)
▪ H0: Chinese (Shanghai) equity markets do not share a long
run equilibrium relationship with equity markets of the
Philippines
▪ H1: Chinese (Shanghai) equity markets do share a long-run
Philippines.
16
7. Japan
▪ H0: Japanese equity markets do not share a long-run
Philippines
▪ H1: Japanese equity markets do share a long-run
Philippines.
8. South Korea
▪ H0: South Korean equity markets do not share a long-run
Philippines
▪ H1: South Korean equity markets do share a long-run
Philippines.
1.5. Significance of the Study
Futures trading, in theory, augments capital surge by mitigating risk and

efficiently reallocating the risk associated with various capital modes such as bank loans,
stocks, bonds, and international trade. However, the forced development of an industry
not prepared for growth may result in disastrous consequences, much like the steel
industry in China’s Great Leap Forward. As such, prudent regulations with the goal of
stabilizing market volatility will cause various sectors crucial to the economy to benefit.
For the purposes of this study, the researchers will focus on financial institutions,
institutional and retail investors, speculators, financial policymakers, and regulatory
bodies.
1. 5. 1. For Financial Institutions
While financial institutions may engage in proprietary trading, or “prop trading”,

the primary use of derivatives in financial institutions is to manage the risks it faces. For
17
instance, interest rate risks have a negative impact in the bank lending process as it
decreases its loan capacity to the borrowers. But because of derivatives, the interest rate
risk could be reduced allowing the bank to expand their lending activities, which would
generate higher returns for these banks (Deshmukh, Greenbaum, & Kanatas, 1983).
Derivatives also help financial institutions to lessen the expected costs of financial
distress by minimizing the irregularity in firm value. As discussed by Prahba, Savard, and
Wickramarachi (2014), variance between assets and liabilities exposed banks to interest
rate risk but derivatives cut the risk that translates into profitability and capital adequacy,
as well as lowering the chances of bank failures. In addition to those, derivatives help the
banks to meet the risk management needs of their borrowers, and thereby decrease their
finance cost. However, should derivatives actually induce volatility, it may jeopardize the
benefits stated above.
1. 5. 2. For Institutional and Retail Investors
Such findings may also affect the decisions of institutional and retail investors. A
futures exchange will provide them with more investment opportunities, which will
enable them to subsequently benefit from their investments in derivatives securities
(Rafael & Pilar, 2002). Moreover, the potential for profit will attract an increased number
of traders and investors, which can be divided into three categories, namely: arbitrageurs,
hedgers, and speculators (Hull, 2012).
Arbitrageurs are the traders who take advantage of the mispricing of a security in
different markets, essentially exploiting the failure of the law of one price. On the other
hand, speculators are traders who use derivatives to “wager” on future price movements
of various assets, such as the derivatives themselves. Finally, hedgers are traders who use
derivatives to mitigate their exposure to the price volatility of a certain asset; however, it
must be noted that hedgers do not attempt to profit from these price movements; rather,
hedgers use derivatives to simply manage the risks they face (Hull, 2012). While
investors
18
may, at times, take on the role of a speculator, the primary role of an investor would be to
use the derivatives to manage risk.
Institutional investors, which include corporations and financial institutions, may

also benefit from the presence of a derivatives market in the Philippines by enabling them
to reduce their exposure to certain risk by means of hedging. In practice, derivatives
trading is being used by the airline industry to minimize their exposure to the volatility of
jet fuel. According to Abbey (2011), businesses have to successfully and effectively
minimize their exposure to risk in order to survive in the industry. Abbey (2011) further
mentioned that in the airline industry, companies such as the British Airways as well as
Southwest Airlines have been benefitting from the use of derivatives as they are able to
minimize their exposure to the price volatility of jet fuel.
However, it is also important to note that a futures exchange that causes prices to
unnecessarily fluctuate may cause more harm, as it will create the problem it is designed
to avoid. Thus, it will cause investors to incur higher transaction costs in an effort to
hedge risks which in turn may cause market inefficiency, thereby creating a negative
spillover effect.
1. 5. 3. For Speculators
According to Brunnermeir & Pedersen (2009), the presence of speculators in a
market is crucial, as it enhances the liquidity of the market by taking the opposing side of
the hedgers’ trade. Liquidity can be defined as the ease of which trade can be executed.
While the presence of too many speculators can increase the volatility of the market, their
presence cannot be understated. Moreover, futures trading can become a lucrative market
that speculators can participate in. This is due to its reliance on margin trading, as well as
that most trades are simply closed out with an opposing side, rather than actual delivery
of products (Hull, 2012). Hence, the presence of such a market can become a profitable
trading activity, while supplying liquidity to the market.
19
1. 5. 4. For Financial Policymakers and Regulatory Bodies
The introduction of derivatives products and a formal exchange indicates the

promotion of capital markets development. In the Philippine setting, derivatives market is
relatively underdeveloped, but nonetheless, the Bangko Sentral ng Pilipinas (BSP) aims
to provide a stronger and sound supervisory framework for derivatives trading activities
among banks in the country through Circular No. 594 (Velasco, 2014). The significance
of measuring the effects of futures listing on spot market risk is often associated with the
extensive impact that an efficient capital market has on the domestic economy, both on a
microeconomic and macroeconomic level. This is especially due to the role of the banks
and securities firms as financial intermediaries. These financial intermediaries help retail
and institutional investors deal with financial market volatility. Although, the activities of
these financial intermediaries are limited as they are closely supervised by the Central
Bank and to some extent, the SEC. Thus, financial policymakers and regulatory agencies
may use the findings to justify their policies and actions (i.e. a basis for their supervisory
framework); thus, leading to a more efficient financial market in the country.
Hohensee and Lee (2006) have explained the discrepancy with regard to the level of
financial market sophistication by proving that there is an inverse relationship between
market maturity and regulatory restrictions. In countries with stricter regulatory policies
such as Indonesia and Malaysia – they lag behind relative to its Asian neighbors in terms
of their development in derivatives market. Whereas, countries with lenient regulatory
policies, such as Singapore and Hong Kong, have more sophisticated financial markets
and in fact, they are one of the leading markets in Asia (Hohensee & Lee, 2006;
Fratzscher, 2006). Thus, it would be imperative for financial policymakers including the
regulatory bodies, to re-assess and re-evaluate their policies so as to further promote the
development of capital markets in light of the relatively sustained economic growth in
the ASEAN region. However, it is important to note that if strong regulatory resistance
creates stability within the financial markets, it may be a more viable option for the
foreseeable future.
20
1.6. Scope and Delimitations of the Study
The dataset will be comprised of the stock market indices of ASEAN-5 plus 3
economies that currently have organized derivatives exchanges, namely: (1) Singapore
(STI); (2) Malaysia (KLCI); (3) Indonesia (JCI); (4) Thailand (SET); (5) Hong Kong,
China (HSI); (6) Shanghai, China (SHCOMP); (7) Japan (NKY); and (8) South Korea
(KOSPI). These economies were selected based on their proximity to the Philippines, as
well as economic and demographic similarities. As for the Chinese economy, the
Shanghai Composite Index and the Hang Seng Index are chosen, as they embody the
“one country, two systems” philosophy that belies the People’s Republic of China and
Hong Kong relationship. Furthermore, it is assumed that the stock market indices are
indicative of the economy’s financial performance, as opposed to Roll’s critique. The
GARCH model will be used to quantify the volatility of these indices, and ascertain the
relationship between the return volatility of the stock market with futures exchanges and
futures trading. Finally, the long-run cointegration test will also be conducted between
the market indices enumerated above and that of the Philippines (PSEi), in order to test if
the equity markets in the sample set move together.
The periodicity of the data is daily sampling, which will be used for the testing on the
volatility effects of futures listing, futures trading, and for the cointegration of the nine
financial markets in Southeast and East Asia. To ascertain the effect of futures listing to
stock market volatility, the data will be comprised of a 5-year window before and after
the establishment of the derivatives market in the host country. The exact date will differ,
as each country established their derivatives exchange on different dates. The time frame
is similar to the time frame employed by Sakthivel and Kamaiah (2011); whereas, the
data selection method is similar to the method utilized by Gulen & Mayhew (2001).
Next, to proxy the trading activity, the open interest and trading volume of the futures
exchange of each economy will be obtained. Open interest indicates the total number of
open futures
21
contracts at the end of each trading day; whereas, trading volume refers to the number of
contracts traded on a given trading day (Bessembinder & Seguin, 1992).
As with the data collected by the previous studies, the data’s characteristics are
assumed to be slightly leptokurtic, due to the inherent volatility of financial markets. The
data, however, will still be subject to empirical testing to ensure that these characteristics
are indeed exhibited. As with any study, the available dataset from Bloomberg terminal is
also assumed to be complete and accurate.
22
CHAPTER 2
REVIEW OF RELATED LITERATURE
Various studies on the effects of futures listings on the volatility of the underlying
equity market or spot market have been conducted worldwide, particularly on countries
with sophisticated capital markets. The recent literature in this field does not give any
clear and conclusive views due to the uniqueness and individuality of stock markets of
each country. Thus, the results tend to be controversial and contradict one another.
Furthermore, there is a scant research and understanding on the effects of futures listing
on spot market volatility in the ASEAN region which limits the researchers on giving a
sound basis for comparison; therefore, they opted to add relatively matured financial
markets in the East Asia region such as that of South Korea, China, and Japan.
This chapter will begin with the inception of Asian derivatives market,
particularly in economies like Japan, Hong Kong, Singapore, India, Korea, China,
Malaysia and the Philippines. Followed by the previous studies on cointegration of Asian
stock markets to further support the researchers’ alternative hypothesis of Asian equity
markets having a long-run relationship. To explain thoroughly the different results of the
derivatives market effects on stock volatility, the researchers divided the recent studies
into three parts; those which reduces volatility, those which induces volatility, and those
which has mixed effects or no effects at all. With this, the researchers could determine
the most applicable data and method in this venture.
2. 1. The Derivatives Market in the ASEAN Region
Back in 2006, South Korea is number one in derivatives exchange while India is
the fastest growing derivatives exchanges worldwide, both countries are specializing in
equity derivatives trading. Fratzscher (2006) reported in his article in World Bank that
derivatives market in Asia comprised one third of the world foreign exchange during that
23
time. According to the author, Asian derivative markets are gradually shifting from OTC
to ETD.
There are three stages of formal derivative exchanges in Asia according to

Fratzscher (2006). First is the exchange in Japan, Australia, Hong Kong, and Singapore
with high interest volatility, foreign exchange, equity, and commodity products. They are
called the major Asian exchanges. Second is the exchange in Korea, India, China, and
Malaysia. Korean Stock Exchange for equity derivatives merged with KOFEX for fixed
income derivatives and created the Korean Futures Exchange in 2004. During that time, it
was the largest futures exchange in terms of trade volume worldwide offering low-cost
and technologically efficient derivative products. India focused on retail trading of equity
derivatives, while Malaysia instituted the Malaysian Derivatives Exchange for commodity
and equity futures trading in 2001. Third is the exchange in Thailand, Indonesia, and the
Philippines. Thailand Futures Exchange introduced the interest rate derivatives after some
OTC derivatives losses due to adverse movements in foreign-exchange rates in 2004,
whereas the Jakarta Futures Exchange initiated equity index futures at Surabaya Stock
Exchange in 2001. Lastly, Philippines adopted the OTC derivatives trading through the
establishment of the Manila International Futures Exchange (MIFE) in 1985; however, it
was terminated due to fraud issues by the government officials and stock brokers in 1997.
Fratzscher (2006) found that over 60% of big establishments in Asia mostly trade in
OTC markets, specifically fixed income or foreign exchange derivatives. Asian derivative
markets are mainly influenced by the risk allocation benefits in capital markets,
corporate demand for hedging instruments, better liquidity due to cross-border flows or
trade integration and low-cost electronic trading. He concluded that equity derivatives
have mitigated volatility, boosted liquidity in equity markets, enhance investor returns,
and reduced cost of equity listings for firms.
Alan, Karakozoglu, and Korkmaz (2015), analyzed the performance, focusing on

hedging and pricing efficiency, of Turkish stock index futures (BIST 30) in contrast to the
24
Taiwanese (TAIEX) and Korean (KOSPI 200) futures exchanges back when both markets
were emerging. Their study is pertinent in stimulating the development of new stock
index futures in emerging economies. The authors have tested the cross-market volume
volatility linkage and the results showed that in BIST 30, the causality in the futures
exchange is unidirectional – from volume to volatility, while the opposite is true for the
spot exchange. The Granger causality for TAIEX is also one-way – from volume to
volatility in both the spot and futures market, and for KOSPI 200, such causality is
merely existent suggesting that the Korean market is speculative. Furthermore,
mispricing occurs during the initial years of futures trading as evidenced in BIST30 and
KOSPI 200 since speculative trading is common in both markets but BIST30 is poised to
reap substantial increase in its “hedge effectiveness” as compared to the other two
futures exchange.
2. 2. ASEAN Stock Market Cointegration
Several empirical studies proved that there is a long-run relationship between the
Philippines and other Asian countries (Karim & Gee, 2006; El-wassal, 2005; Puan, 2009;
Janor & Ali, 2007). All of these studies explained that financial liberalization plays a
huge role in the stock market cointegration of Asian economies specifically in the
ASEAN-5: Thailand, Indonesia, Malaysia and the Philippines. Based on collaborating
results, it was found that there is causality between the stock markets of the Philippines
and Malaysia.
El-Wassal (2005) studied the link between stock market growth and economic
growth by including market size and market liquidity of the stock market as development
indicators, and Industrial Production Index (IND) as the real economic activity indicator.
Employing both the Johansen Cointegration and the Granger Causality test, he found that
among twelve emerging economies, only India, South Korea, Zimbabwe, Malaysia, and
the Philippines have a causal relationship among the stock markets and economic growth.
Furthermore, El-Wassal (2005) discovered that among the five economies, it was only
Malaysia, Philippines, and Zimbabwe stock market that has a two-way causal
relationship.
25
Karim and Gee (2006) discussed that globalization was able to eliminate trade
barriers and henceforth increase cointegration among stock markets. The authors have
applied bivariate Vector Autoregression model (VAR) and Vector Error-Correction
Models (VECM) to measure the short-run and long-run cointegration of stock indices of
Malaysia and other major trading partners such as the Philippines, Thailand, Indonesia,
Japan, China, Hong Kong, and the United States. The data acquired was the daily closing
prices from January 4, 1994 to December 31, 2002 to take into account the pre and post
financial crisis. The researchers then converted the stock indices to natural logarithms
before executing any empirical tests. Also, they determined the number of lags through
the use of Akaike Information Criterion (AIC) and Schwarz Criterion (SC). As per Karim
and Gee (2006), cointegration test is only applicable if the time series used is non
stationary, which resulted in them using the unit root tests. They found that there is an
existing long-run relationship between Malaysia and the Philippines stock market pre
financial crisis such that the daily price movement of the Malaysian stock market leads
the price movement of the Philippines in the long-run, whereas Indonesia and China in
the short run. Yet, after the financial crisis, cointegration was reduced.
Janor and Ali (2007) assessed the global and regional financial integration of the
ASEAN-5 countries: Malaysia, Singapore, Thailand, the Philippines, as well as Indonesia
before, during, and after the Asian financial crisis in 1997. The data they used is
comprised of the monthly closing prices of the Philippines’ Composite Index,
Indonesia’s Jakarta Composite Index (JCI), Thailand’s Bangkok SET., Singapore’s
Straits Times Index (STI), Malaysia’s KLCI, and major world indices that include the
S&P 500 Composite for the US, Nikkei 225 Stock Average for Japan, and the Morgan
Stanley Corporation (MSCI) world price index within the period of April 1983 to
December 2006 and for January 1986 to December 2006 for the Philippines.
26
Janor and Ali (2007) tested the long-run correlation among the Asian markets by
applying both bivariate and multivariate cointegration methods. They used the Johansen
cointegration test to determine the number of cointegration vectors through maximum
likelihood approach. Notably, the results showed that the Philippines is cointegrated with
its regional counterparts in the ASEAN excluding Thailand. During the full financial
crisis period, only the Singaporean market was cointegrated with its counterparts in the
ASEAN except the Philippines. Finally, during the post-global financial crisis, they
found out that Japan is cointegrated with all the capital markets considered except for
Singapore. Thus, they suggested that the financial integration is not yet complete which
is why portfolio diversification is significant in ASEAN markets. The researchers noted
that multivariate approach is more reliable, as the bivariate approach does not show that
the integration is fully complete; therefore, markets are vulnerable from diversification
benefits and global stock market effects.
Phuan (2009) explained in his paper that due to financial liberalization, the stock
markets integration increased. According to the author, Thailand, Indonesia, Malaysia
and the Philippines was positively influenced by the other stock markets after the
financial liberalization whereas Singapore was unaffected. This paper utilized the daily
closing values of Indonesia’s Jakarta S.E. Composite, Thailand’s Bangkok SET,
Singapore’s Straits Time Index, Malaysia’s Kuala Lumpur Composite, as well as the
Philippines Stock Exchange Composite from February 1, 1986 to 1997 to avoid the
financial crisis era. As for the methodology, the Johansen and Juselius multivariate
cointegration was used to determine the long-run relationship using maximum likelihood
procedures so as to identify the number of cointegration vectors among a vector of time
series. Moreover, granger causality test was also applied for the short-run relationship.
Based on the results, ASEAN-5 stock markets has a causal relationship which implies
that they tend to move in the same direction and that they have long-term benefits to
international diversification.
27
2. 3. Derivatives Mitigating Spot Market Volatility
Stock index futures have been the topic of interest of many researchers today.
Some would argue that futures trading induces the volatility of the equity market because
it attracts uninformed traders with high levels of leverage to engage in the trading of
futures (Kasman & Kasman, 2007). However, others contest that futures trading may
actually be beneficial to the equity market by increasing market depth and efficiency
through hedging opportunities provided by the trading of derivatives (Kasman &
Kasman, 2007). Despite all these evidences, most of the studies conducted have only
considered the effects of trading such financial assets in a developed economy such as
the United States and Europe. Coming from this standpoint, Kasman & Kasman (2007)
attempted to replicate the same studies in a developing or emerging economy, more
specifically, the Turkish economy. The researchers conducted a study to determine the
impact of futures trading on the Istanbul Stock Price Index 30 (ISE-30) volatility.
Using asymmetric exponential GARCH model, or Generalized Autoregressive

Conditional Heteroskedasticity, and data that comprise of daily closing price index from
July 1, 2002 to October 8, 2007, Kasman & Kasman (2007) were able to find that the
introduction of a derivatives market has helped stabilize, or reduce, the volatility of the
ISE-30. Furthermore, the researchers also mentioned that the markets that exhibit the
same attributes or characteristics as the Turkish stock market may also reap benefits from
the introduction of a derivatives market. Thus, the researchers concluded that the
introduction of the derivatives market to the Turkish stock market has been deemed
beneficial to the economy, thereby increasing market efficiency.
Nair (2008) investigated the impact of derivatives trading on spot market volatility
by employing the symmetric and asymmetric GARCH models. He analyzed daily closing
prices of each in the Indian Stock Market for the period January 1997 to August 2007.
First, he considered the before and after futures trading volatility. Next, he examined the
presence of heteroskedasticity in the asset return series given that the underlying stock is
28
an index. Moreover, heteroskedasticity exists in the dataset when the null hypothesis that
the disturbances have constant variance is rejected. In addition to that, estimators would
have higher variances if there is heteroskedasticity and thus, they are no longer efficient
(Gujarati and Porter, 2009). It must be noted, however, that the standard GARCH models
presume symmetry in the response of information volatility, which is not always the case.
To test the information asymmetry, each asset was analyzed individually for the
pre-introduction, post-introduction and full period of derivatives market using the GJR
GARCH(1,1) specification of volatility dynamics. The GARCH coefficients are then
generated to examine the change in the unconditional variance, the information efficiency
held into spot prices, and the relationship between information and volatility subsequent
to the introduction of derivatives trading. In order to determine the correlation between
information and volatility as a result of derivatives trading, a dummy variable D was
applied in the conditional variance equation using a pre- and post-zero value. Based on
the results, the introduction of derivatives trading had an effect on the volatility to new
information. Moreover, it was found that “news coefficient” following the introduction of
derivatives trading increases asset return volatility. This implies that there is a surge in the
quantity of information into the spot market. To test the normality of data, Jarque-Bera
(JB) test statistic is employed followed by chi-square distribution and Lagrange
Multiplier test to examine the presence of autocorrelation. Ultimately, the findings of the
study indicated that derivatives trading has an effect in reducing spot market volatility.
However, there is an insignificant effect in settling asymmetric response of volatility to
information in the market.
Sakthivel and Kamaiah (2011) attempted to evaluate the effects of derivatives

trading, particularly futures trading, on the underlying spot market. According to them,
this may take one of the two paths. It may increase volatility due to the diminished
trading costs and increased opportunities for leverage, thereby creating incentives to
manipulate the underlying market index. Alternatively, it can decrease volatility due to
the migration
29
of speculators from the spot market to the futures market—in essence, the futures market
absorbs the underlying spot market volatility. This argument is further reinforced by the
notion that the presence of a futures exchange increases market efficiency by mitigating
information asymmetries.
To assess the relationship between the existence of derivatives market and equity
market volatility, the authors collected the daily closing prices of the NIFTY, as well as
27 other stocks from the NSE from January 1, 1997 until February 28, 2008. All of the 27
stocks assessed had a listed stock future based upon it. The volatility of the underlying
security was measured using the GJR-GARCH model, in separate time series analyses.
GJR-GARCH, otherwise known as the Glosten-Jagannathan-Runkle GARCH model, is a
non-symmetric extension of the GARCH model, which compensates for the original
model’s susceptibility to time-varying volatility.
The presence of a derivatives market was then signified using a dummy variable,
with its value and degree of significance indicating the relationship between volatility and
the presence of a derivatives market. Assuming that the values were significant, a positive
relationship would imply that derivatives markets magnify volatility, while a negative
relationship would imply that derivatives markets mitigate volatility. An insignificant
relationship would imply that the effects exuded by the presence of a derivatives market
is not statistically significant, and thus, irrelevant.
Initial empirical tests reveal that the dataset is stationary at first difference,
indicating that the market forces acting upon the dataset are not extremely complicated
and that the residual effects of previous data points are not carried over very far. However,
the dataset is slightly negatively skewed and leptokurtic, indicating that the dataset
exhibits a tendency to lean towards the negative values and a higher kurtosis—a higher
kurtosis would indicate a higher level of variation within the data set. However, GJR
GARCH results would indicate that the dummy is significantly negative. As a result, the
30
authors were able to conclude that the presence of a derivatives market actually helps
mitigate the volatility experienced by the underlying market.
Matanovic and Wagner (2012) have contributed to the literature by examining the
impact of volatility on DAX, traded in Germany, futures trading. Similar to other studies,
they applied the GARCH(2,1) model to determine the volatility. The authors also
controlled the irrelevant macro-wide factors with respect to futures trading by including a
proxy variable in the conditional mean equation. Interestingly, they found that the
volatility has decreased following DAX futures trading; however, the effect did not
transpire immediately until a year or two later. Nonetheless, their study validated the
stabilizing hypothesis. They further emphasized that having a long-period of observation
for post-listing better captures the overall impact of volatility on futures trading.
Bohl, Diesteldork, and Siklos (2014) studied the effect of establishing the CSI300
index futures (traded in Shanghai) on spot market volatility relative to HSEI (traded in
Hong Kong) and China A50 (traded in Singapore) derivatives and equity markets. It is of
note that Chinese market is mostly comprised of retail investors due to high barriers to
entry to foreign institutional investors and that there is an increasing number of
speculators relative to other emerging markets.
Similar to most studies, they used the different specifications of GARCH model to
measure volatility as they use daily frequency data. Bohl et al. (2015) found that the
listing of CSI300 index futures has a negative and significant impact on the CSI300 spot
market volatility, and on both HSEI and A50 spot markets; hence, in favor of the
stabilization hypothesis. Per definition of Siopis & Lyroudi, (2007), stock market
destabilization refers to the increase in its underlying volatility while the stock market
stabilization refers to the decrease or no change in the underlying volatility. Moreover,
they also found evidence for the positive spillover effects between A50 and both the
CSI300 and HSEI that may be due to the influence of Chinese authorities. On the other
hand, there is a negative spillover effect between CSI300 spot market and HSEI, as both
are commonly termed as sister
31
markets. Although China’s stock market is young and has a moderately regulated futures
exchange, their market can be classified as relatively mature (Bohl et al., 2015).
2. 4. Derivatives Inducing Spot Market Volatility
In an attempt to receive above-average risk-adjusted returns, investors resort to

using arbitrage derivatives trading strategies on stock market indices. These strategies are
believed to increase price volatility because order imbalances that lead to the identical
movement of stocks included in the index are made (Chang, Cheng & Pinegar, 1999).
Further, since the price volatility associated with stock index futures trading impact the
market negatively, this kind of strategy in trading is often frowned upon.
Chang et al. (1999) conducted a study that attempted to determine whether futures
trading on Singapore International Monetary Exchange (SIMEX) and Osaka Securities
Exchange (OSE) actually led to an increased volatility in the Nikkei. Using “single-factor
return-generating” model on the daily closing returns of 122 firms listed in the Tokyo
Stock Exchange, the researchers have attempted to isolate the effects of various broad
economic factors and futures trading on volatility.
Results indicated that stocks included in the Nikkei stock index exhibited an
increase in spot volatility and a decrease in cross-sectional dispersal, relative to average
volatility, after futures trading commenced in the OSE. However, no significant changes
in volatility were observed when futures trading began on the SIMEX. For stocks not
included in the composition of the Nikkei 225, no shift was observed after futures trading
commenced on either market. This is actually consistent with the phenomena that the
impact of futures trading on stock market indices does not spillover the stocks not
included in the index composition, and that the impact on the volatility of Nikkei is
caused by futures trading and not by broad economic factors (Chang et al., 1999).
32
Kang and Yoon (2007) examined whether Asian spot markets are affected by
index futures trading by taking into account the asymmetric volatility using the classic
GARCH, GJR-GARCH, and APGARCH, or known as Asymmetric Power GARCH,
models. Their study has covered five Asian spot markets namely: Japan (TOPIX), South
Korea (KOSPI 200), Malaysia (KLCI), Straits Times (Singapore), and TAIEX (Taiwan)
for a period of ten years with daily frequency. Similar to Matanovic and Wagner (2012),
the authors divided their dataset into pre-futures and post-futures periods. Through the
GJR-GARCH, which was deemed to be more suitable in incorporating asymmetric
volatility, they have identified that the establishment of futures listing in the market gives
rise to volatility asymmetry contrary to the findings of Antoniou, Holmes, and Priestley
(1998). Furthermore, the APGARCH specification is more advantageous because it gives
detailed descriptions of the data. Consistent with GJR-GARCH, the coefficients for
volatility asymmetry were positive and significant via APGARCH–implying that futures
listing increase asymmetric volatility among the Asian stock markets. Therefore, their
findings have generally showed support to the destabilization hypothesis.
2. 5. Derivatives Showing Unchanged and Mixed Effects on Spot Volatility
Bessembinder and Seguin (1992) explored the implications of derivatives trading

on the volatility of prices within a stock market. Unlike other studies, it does not assess
the effect of the existence of the derivatives market; rather, it tries to see the effect of
trading itself. Hence, it allows the data to be deconstructed and it will show the effects of
derivatives trading post-establishment of the exchange. According to the authors, there
can be two possible relationships between trading volume and price volatility. The first
would be a positive relationship, wherein an increase in the trading volume would cause
an increase in price volatility. This is caused by a phenomenon they called “mixture of
distributions”, which occurs because of the sequential nature of the arrival of information.
Moreover, this also causes information shocks, which then spurs trading activity, and
33
thereby price volatility. The other possibility would be that there is a negative relationship
between these two factors, which would imply that mispricing would become less
prevalent due to more efficient markets and a freer flow of information.
To conduct the analysis, daily data on the S&P 500 was collected from January
1978 until September 1989. Prices and volumes of futures contracts were collected from
Columbia University Futures Center, with a specific focus on index futures. Index futures,
as noted by Bessembinder and Seguin (1992), are popular because these contracts
provide more exposure to the market at decreased costs. The authors then used the
ARIMA (0,1,10), or Autoregressive Integrated Moving Average model, which
decomposed the data into expected and unexpected components. Expected components
are defined as variable, but foreseeable trading actions, while unexpected components
are daily activity shocks. Furthermore, by decomposing data into these two categories,
the authors were then able to see how each factor would affect the volatility within the
market. After running the empirical procedures, they were able to see that unexpected
futures trading increased volatility. Interestingly, however, they found out that expected
futures trading has actually decreased volatility, implying that futures trading has, in
general, a stabilizing effect on the equity markets.
Gulen and Mayhew (2001) examined how stock index futures trading affected
stock market volatility in international markets. The authors attempted to show how
derivatives markets affected the equity markets of emerging countries, or countries with
emerging derivatives markets. To do so, they collected the daily stock market indices
from January 2, 1973 until December 31, 1997 covering most European and other
developed financial markets. To assess the data, they utilized multiple models that would
capture the volatility of the dataset. All the models are iterations of the GARCH model
in a time-series analysis scenario; these iterations differ in their assumptions of the
dataset, and therefore, their treatment of the data. First, the authors conducted their
analysis through a univariate GARCH model, which would isolate the effect of the
presence of the derivatives market
34
on volatility. This would then help eliminate the presence of time-specific volatility. The
multiple iterations of the univariate GARCH model are the following: (1) the Bollerslev
Specification, which assumed that there is a symmetric response to either a positive or
negative shock; (2) the GJR-GARCH, which, as explained earlier, assumes that there is
an asymmetric response to positive and negative shocks; (3) the N-GARCH, which is a
non-linear GARCH model, and finally, (4) the E-GARCH, which is an exponential
GARCH model. After running the specification tests, however, the GJR-GARCH model
emerged as the best model to use. Once again, a dummy variable was used to capture the
presence of a derivatives market.
To conduct the univariate analysis, two functional forms were used: first, the
multiplicative dummy model. This places the dummy variable as a multiplier of the entire
model; thus, showing the effect of the presence of the derivatives market. It magnifies
further the difference, or contrast, between the conditions of both states. Next, the
additive dummy model was used. This would now show the isolated relationship shared
between the presence of derivatives market and the volatility experienced by the
underlying market. The second iteration of GARCH used in the paper was the
multivariate iteration, specifically, the BEKK specification of multivariate GARCH. The
BEKK M-GARCH model, otherwise known as the Baba-Engle-Kraft-Kroner
Multivariate GARCH model, is a popular multivariate specification of M-GARCH,
especially applicable to financial studies due to its characteristic of positive definiteness
(Su & Huang, 2010). This was selected through specification tests; it allowed the authors
to show the real-world dynamic interaction among “world-market volatility,
country-specific volatility, and conditional covariance” using the time-varying
conditional covariance in a way that would not bias the data. In doing so, the authors
showed a more realistic view of the dynamic interaction between volatility and the
presence of a derivatives market. Finally, in order to ensure that the variations in
volatility can be attributed to the derivatives market, the authors adapted the study of
Bessembinder and Seguin (1992), wherein they employed the ARIMA model
35
to decompose the trading activity into expected and unexpected components. These
components are then reintroduced into the additive univariate model—this is to get the
individual effect of each trading action.
The authors, Gulen and Mayhew (2001) after conducting all their empirical tests,
reached the conclusion that the presence of a derivatives market does generally reduce the
volatility of the underlying equities market. Although each model had slightly different
results, they all support the general conclusion of the paper. However, an interesting
result that the authors found was that the level of development of the market affected the
stabilizing effect of the derivatives market. In highly developed markets such as the
United States and Japan, the presence of a derivatives market actually fuelled volatility.
This is possibly due to the fact that the development and depth of the market actually
empowered speculators to generate excessive volatility in the market.
As posited by the efficient market hypothesis, prices adjust according to the

entrance of new information. However, the price adjustments or the volatility associated
by such information can be decomposed into four specific types of volatility, namely:
“FTSE100 index return volatility, return volatility for futures on the FTSE100 index, and
FTSE100 index American and European call option volatilities”; all of which sum up to
what the researchers call as “transitory noise” and “unobserved fundamental volatility”
(Hwang & Satchel, 2000). Using stochastic volatility models, the researchers were able to
isolate the effects of derivatives trading on each specific type of volatility. Moreover, the
effect on the FTSE100 index and futures return volatility exhibited larger transitory noise
rather than fundamental volatility, while the American and European call options were
observed to comprise mostly of fundamental volatility rather than the transitory noise
(Hwang & Satchel, 2000). However, due to the small number of observations used in the
study, the researchers was not able to reach a conclusion as to whether the introduction of
a derivatives market, specifically a futures as well as an options market, had an effect on
the FTSE100 index. Nevertheless, Hwang and Satchel (2000) were able to conclude that
36
the underlying market and the other existing derivatives market had a stabilizing effect
after introducing a new options market.
As numerous studies attempt to determine the effect of introducing a derivatives

market into the stock market, scholars have tested various econometric procedures on
different datasets. However, researchers end up having mixed conclusions. In this light,
scholars have been divided as to whether introducing a derivatives market would be
beneficial to the market. Supporters of this theory such as Rafael & Pilar (2002), assert
that derivatives market improves the way at which information is transmitted; hence,
information asymmetry is reduced, leading to the possible decline in the level of
volatility. However, others would dispute that the presence of arbitrageurs and
speculators in the derivatives market could encourage investors in the spot market to
transfer their investments into the derivatives market; decreasing liquidity in the spot
market, thus leading to increased levels of volatility (Skinner, 1989).
In order to determine whether derivatives trading reduced volatility in the Spanish

stock market, Rafael & Pilar (2002) used GARCH, EGARCH, and GJR-GARCH. The
researchers used the daily closing prices and trading volume of the Spanish stock index
(IBEX 35) from October 1990 to December 1994. Results indicated that the introduction
of a derivatives market stabilized the index. Thus, a positive effect was observed from
trading derivatives on the index. Furthermore, the IBEX 35 also exhibited an increase in
trading volume together with the decrease in the level of volatility; hence supporting the
theory that liquidity and volatility are inversely related (Skinner, 1989). The researchers
also noted that implementing further restrictive regulations on a derivatives market could
hamper the potential benefits that could be received from it, limiting the possibilities in
investment. Finally, Rafael & Pilar (2002) stressed that a market that exhibited similar
attributes to that of the Spanish market could also benefit from the introduction of a
derivatives market. In doing so, it would expand the opportunities available for
investment and improve the efficiency of the market (Rafael & Pilar, 2002).
37
Malikkarjunappa and Afsal (2008) used the S&P CNX Nifty Index, largest traded
volume among the derivatives products in India, to analyze the behavior of the market
with respect to volatility via the GARCH model. The findings of their study showed that
there is no stabilizing or destabilizing effect after the introduction of derivative in the
market. Moreover, they noted that the changes in the volatility of the underlying spot
market may be due to many market-wide factors such as information transmission. This
was later on refuted by Sakthivel and Kamiah (2011) as presented in the earlier section.
Nevertheless, Malikkarjunappa and Afsal (2008) have identified that the day-of-the-week
effect diminishes after derivatives were introduced in the market.
2. 6. Synthesis and Research Gap
In light of the ever-changing global economy, most financial markets have been
developing various means to adapt to such changes. In response to these developments,
emerging economies have introduced formal derivatives exchanges in an attempt to
increase market efficiency and to maximize the potential of their markets, and match the
level of development of their international peers. These derivatives exchanges are able to
do so by optimizing information flow, and absorb excessive speculative activity. However,
studies conducted in an array of economies have shown inconsistent results; leaving the
question as to whether the introduction of a formal derivatives market would be indeed
beneficial to an economy.
Studies that were conducted by Kasman & Kasman (2007), Nair (2008),
Sakthiviel & Kamaiah (2011), Matanovic & Wagner (2012), and Bohl et al. (2015)
concluded that the introduction of a formal derivatives market reduces the volatility of
the stock index of a country; thereby increasing market efficiency. However, Chang et al.
(1999) and Kang & Yoon (2007) arrived at contradicting results implying that rather than
inhibiting volatility in the equity market, derivatives trading actually induces volatility in
the market. Having seen both ends of the spectrum, some authors such as Gulen &
Mayhew (2001),
38
Pilar & Rafael (2002), and Malikkarjunappa & Afsal (2008) even failed to arrive at
definitive results in their respective studies. In this regard, the researchers of this study
intend to present conclusive results, backed up by empirical evidence and supported by
the existing literature, as to whether the introduction of a formal futures market would be
beneficial to the Philippine financial system or not.
Although the effects of formalized futures markets have been thoroughly

examined in the literature, the researchers have found that most of these studies have
been conducted before the year 2008. Furthermore, the data is somewhat limited to the
effects on highly developed markets, such as the United States, or that of Japan. Studies
into emerging markets are oftentimes limited to one market only, which would not show
the effect of a formalized futures market on a diverse range of markets. In addition to
this, based on the researchers’ knowledge, no attempt has been made to link these studies
to the Philippines just because the country has no formalized derivatives market yet, or to
analyze what effects the sophisticated market may have on domestic markets.
The proponents will therefore attempt to fill this hole in the literature by analyzing the
effects of a formalized futures exchange on Southeast and East Asian region, as these
economies have a diverse range of political and economic systems and varying levels of
regulation. However, the underlying demographic and cultural ties ensure that these
economies act as viable proxies for the domestic Philippine market, thereby allowing the
researchers to fill the other gap relating to the lack of studies regarding the Philippines.
By employing multiple countries with varying levels of economic development and
regulatory freedom, the researchers are able to maximize the relevance of the study to the
Philippines, as there is no empirical evidence to either theory for the Philippine domestic
market, based on the researchers’ knowledge.
39
2. 7. Literature Map
Impact of futures trading on the underlying equity market
of Southeast and East Asian Economies
Cointegration of ASEAN-5 and Asian capital markets
Futures derivatives mitigating spot market volatility
Kasman & Kasman (2007)

∙ Introduction of derivatives market to the Turkish stock market increased market efficiency.
∙ It has helped stabilize the volatility of the ISE-30.
∙
Nair (2008)
∙ Derivatives trading has effect in reducing spot market volatility.
∙ There is an insignificant impact in settling the asymmetric response of volatility to information in the market.
Sakthivel & Kamaiah (2011)

∙ The data is negatively skewed and leptokurtic.
∙ The presence of derivatives market reduces spot price volatility and the volatility of individual stock.
Matavonic & Wagner (2012)

∙ The volatility decrease following the introduction of DAX trading; however, there is a lag effect or delay for about a year to
two years.
Bohl, Diesteldorf, & Siklos (2014) ∙ In favor of the stabilization hypothesis. ∙ There is a positive spillover effect
between A50 and CSI300 due to the influence of Chinese authorities.
Futures derivatives inducing spot market volatility
Chang, Cheng, & Pinegar (1999) ∙ Stocks underlying the Nikkei index exhibited an increase in spot volatility. ∙ Index futures
trading do not spillover to stocks not included in the composition of the index.
Kang & Yoon (2015)

∙ Establishment of index futures
increases market asymmetry volatility due to speculative trading.
∙ It is not related in improving
information asymmetry.
Futures derivatives have no or random effect on volatility
Bessembinder & Seguin (1992) ∙ Used the ARIMA model to decompose data into “expected” and “unexpected” components.
∙ Unexpected (expected) futures trading increases (mitigate) volatility.
Gulen & Mayhew (2001)

∙ Used the ARIMA model to decompose data into “expected” and “unexpected” components.
∙ The presence of a derivatves market reduces volatility, but effect diminishes with market development.
∙ Has a stabilizing effect on normal trading, but cannot prevent unforeseen shocks.
Pilar & Rafael (2002)

∙ Information asymmetry was reduced, leading to possible decline in the level of volatility.
∙ But the presence of arbitrageurs and speculators decreases the level of liquidity, which induces volatility.
Malikkarjunappa & Afsal (2008) ∙ Presence of futures derivatives has no effect in market volatility.
∙ It may be due to numerous market wide factors.
∙ The day-of-the-week effect
disappeared after the introduction.
Fratzscher (2006)
∙ 60% of big establishments in Asia are mostly trading in OTC markets. ∙ Equity derivatives reduce volatility, strengthen
liquidity in equity
markets, enhance investors’ returns, and reduce cost of equity listings for firms.
Karim & Gee (2006)

∙ There exists a long-run relationship between Philippines and Malaysia stock markets.
∙ Although after the Asian financial crisis, cointegration was reduced due to many reforms implemented.
Janor & Ali (2007)

∙ Philippines is cointegrated with all ASEAN countries except Thailand during pre-Asian financial crisis.
∙ Japan is cointegrated with the other countries except for Singapore during post- Asian financial crisis.
Phuan (2009)
∙ Due to financial liberalization, the stock markets integration increased. ∙ ASEAN-5 stock markets has a causal relationship
which implies that they move in the same
direction.
40
CHAPTER 3
FRAMEWORKS
3. 1. Theoretical Framework
This chapter reviews the existing theoretical background and literature that will
serve as the foundation of this study. The researchers will discuss the underlying theories
with regard to the impact of derivative trading on spot market volatility, as it is necessary
to clarify the main concepts related to the subject matter. This will also be used for
further development of the model.
3. 1. 1. Efficient Market Hypothesis
As Eugene Fama (1970) contends in his studies, capital markets may exhibit three
kinds of efficiency, depending on the level of information asymmetry, as well as the
ability of speculators to exploit them. As such, the “efficient market hypothesis” (EMH)
posits that capital markets may demonstrate either one of the following forms of
efficiency: weak-form EMH, semistrong-form EMH, and strong-form EMH. Each level
of efficiency asserts different assumptions and conditions in which a market must adhere
in order to be identified as a market exhibiting a particular efficiency level.
Weak-form EMH. The weak-form EMH claims that the current stock prices
already incorporate all historical market information such as previous stock prices,
trading volume, etc. Moreover, this hypothesis also assumes that the previous rates of
return does not affect the future performance (i.e. the future stock performance is
independent). Therefore, technical analysis is rendered irrelevant when the market
exhibits weak-form EMH (Reilly & Brown, 2011).
Semistrong-form EMH. The semistrong-form EMH posits that current stock

prices reflect all public information and that prices adjust rapidly to the entry of new
information. The semistrong-form EMH embodies the weak-form EMH since historical
market information is considered as public information; however, the semistrong-EMH
41
includes nonmarket information including but not limited to dividend-yield, price-to

earnings ratios, economic figures, and political news as public information that is already
incorporated in stock prices. Hence, fundamental analysis will not yield above-average
returns for investors, as all public information has already been incorporated in stock
valuation (Reilly & Brown, 2011).
Strong-form EMH. The strong-form EMH affirms that current stock prices
convey all public and private information such that no investor is able to receive above
average risk adjusted returns using either technical or fundamental analysis. Furthermore,
the strong-form EMH depicts both the weak-form as well as the semistrong-form EMH;
however, the strong-form EMH also covers the assumption of perfect markets, which
implies that all information is freely available for every investor. Thus, even acquiring
insider information would be pointless since stock prices have already considered all
available information (Reilly & Brown, 2011).
Numerous studies have claimed that futures trading reduces the information
asymmetry between the investor and the market. Cox (1976) asserts that futures trading
may affect the price expectations of investors by modifying the information available to
market investors or traders. He further mentions that there are two reasons why futures
trading is able to do so. Firstly, an organized futures trading mechanism entices a new set
of traders to flock the market; these traders are called speculators who only wish to
acquire information to predict prices without actually holding the physical commodity or
asset (Cox, 1976). Secondly, the transaction costs associated with futures trading is
relatively cheaper than trading in the absence of a formal futures exchange (Cox, 1976).
The author confirms that the presence of a formal futures exchange has made it cheaper
for investors to identify potential traders and bid and ask rates; thus encouraging
investors to trade and communicate more information. Cox (1976) concludes that market
prices are able to more effectively reflect and signal signs for resource allocation when
there is futures trading available in a commodity.
42
However, Nair (2008) contends that despite the increase in the number of
investors after introducing a formal derivatives market, the flow of information or the
additional information generated by derivatives trading does not guarantee a more
efficient market. This is due to the fact that traders come in any of the three forms:
arbitrageurs, hedgers, and speculators. The presence of both arbitrageurs and hedgers
seek information, which eventually leads to an increase in market efficiency; whereas
speculators play an ambiguous role where they are able to manipulate the market due to
the high leverage opportunities made available by derivative instruments. Thus, one can
only assume that the effect of having additional information generated by derivatives
trading is dependent upon the purpose for which these derivatives are to be used (Nair,
2008).
3. 1. 2. Stabilization and Destabilization Hypothesis
The concept of volatility in stock market, as used in the empirical literature, is a

measure of the degree, magnitude, and frequency of variations or fluctuations of the
underlying financial asset’s price for a time period (Sevillano, 2011). Alexander (2001)
classified the concept of volatility into two categories: implied volatility and statistical
volatility. Implied volatility refers to the forecast of variations over the life of a derivative
contract that equates an observed market price with the theoretical price of a derivative;
meanwhile, statistical volatility is dependent on the statistical model that a researcher
chooses, such as that of GARCH model that is applied to historical asset prices data
(Siopsis & Lyroudi, 2007).
The stabilization hypothesis posits that the presence of futures exchange reduces
spot market volatility, whereas the destabilization hypothesis states the opposite (Bohl, et
al., 2014). There are also two variants of the destabilization hypothesis, namely: (1) the
populist variant and (2) liquidity variant. The populist variant notes that the spot market
“does not reflect any fundamental economic value”; whereas, the liquidity variant states
that “there is no effect on the underlying volatility in the long-term” (Siopsis & Lyroudi,
2007).
43
There are many factors that cause the destabilizing effect on the volatility, as some
of these were also examined in the literature. As per Moses (2013), the common factors
include asymmetric information, speculative behavior of traders, adverse spillover that
can cause contagion, as well as lack of financial market infrastructure. As briefly
discussed before, asymmetric information exists when an investor or a trader is better
informed than the others and thus, creates an imbalance in financial transactions. This
inversely affects the financial market because of its exposure to excess volatility and may
ultimately result to market failure.
Derivatives products may also induce speculative trading within the market given
its intrinsic nature. The Dispersion Beliefs Hypothesis classifies investors into two –
informed traders with “homogenous beliefs” and uninformed traders with “heterogeneous
beliefs” (Jacobsen & Lind, 2010). The assumptions of this hypothesis are: (1) noise
traders (i.e. speculators) and rational investors (i.e. hedgers) engage in derivatives trading
because of low transaction costs and higher risk premium and to hedge foreseeable risk,
respectively; (2) the trade of speculators should be more significant than hedgers so as to
affect the pricing mechanism (Jacobsen & Lind, 2010).
With that, excess volatility may arise because of the way the speculator interprets
the information they have. Moses (2013) mentioned that herding behavior facilitates the
rapid fluctuations of asset prices and thus, amplifies volatility within the market leading
to instability. Lack of transparency on counterparties’ risk also cause the destabilizing
effect as it magnifies uncertainty and it widens the gap of asset mispricing and thereby,
increase in asset price movements and prolonging the time before the prices correct
themselves (Moses, 2013). He further noted in his study that lack of a strong regulatory
framework with regard to derivatives trading and subpar clearing and settlement system
may create several loopholes in the financial market infrastructure and thereby, reinforce
the destabilizing effect of volatility.
44
The important role of traders in stabilizing market prices is identified by buying

when asset prices are low and selling when asset prices are high, in which there is a
“dampening effect” on price fluctuations. Parchure (2003) has given a theoretical
evidence showing that the introduction of a derivatives market contributes to the
smoothening of volatility in spot market without distorting the price discovery
mechanism. Moreover, he first evaluated a scenario wherein a formalized futures
exchange is operating together with a spot market. As per Awan and Rafique (2013),
futures exchanges are traditionally more volatile relative to spot markets, but the close
relationship between the two markets may spill over risks from one to another.
When there is a rapid change in the supply and demand positions, it is expected
that there will be extreme price fluctuations in the spot market. The spot price will
respond depending if there is a bull market or a bear market. However, Parchure (2003)
has argued that such extreme fluctuations cause the failure of the law of one price; as
such, arbitrage opportunities exist and traders shift to the futures exchange to hedge their
positions. In a bull market, traders will short the underlying asset and enter into a futures
contract to purchase the asset in the future. Whereas, in a bear market, they will long the
underlying asset and enter into a futures contract to sell an asset in the future. Kazmi
(n.d.) noted the significance of traders’ expectations. Being able to effectively hedge
positions in the futures market mitigates extreme price fluctuations in the market. As
such, arbitrageurs take positions to correct the mispricing in the market by absorbing
price movement shocks. Therefore, this phenomenon suggests that in the presence of a
futures exchange, spot market is less elastic to rapid changes in price movements.
3. 1. 3. Theories on Futures Trading
Numerous theoretical studies analyzed the impact of futures trading on the spot
volatility and produced mixed results. Stein (1987) presented two benefits of having more
speculators in the market, the risk sharing and information transmission. According to
him, futures trading has a stabilizing effect on spot volatility if speculators are allowed
45
freely to engage in the spot market, because it fosters more perfectly informed
participants in the market.
In support to the previous framework, Subrahmanyan (1991) created a model for

stock index futures trading wherein he focused on two types of strategic liquidity traders:
discretionary and non-discretionary traders. In his proposition, an increase in noise
trading due to opening of futures exchange makes prices more informative by increasing
the returns to being informed and thus enabling the entry of more informed traders.
However, the number of informed traders must be consistent over time or else it would
have an ambiguous effect on the security price volatility. In addition, Hong (2000) was
able to develop a futures market equilibrium model in which investors are active in
trading to hedge positions and to speculate private information. In his model, he
discovered that investors improve in hedging spot price risk when trading in futures
exchange, which leads investors to take on more superior spot positions. Hence, the
introduction of futures trading may reduce spot price volatility.
3. 1. 4. Arbitrage Pricing Theory

The Arbitrage Pricing Theory (APT) developed by Stephen Ross is a substitute
framework to the Capital Asset Pricing Model (CAPM). The APT states that the returns
of capital assets are being influenced by several systematic factors, yet it only focuses on
the main factors that move group of assets in large portfolios (Roll and Ross, 1975).
Based on this theory, if equilibrium prices have no arbitrage opportunities over static
portfolios of the assets, then there is a direct relationship between the factor structure and
expected returns on the assets (Huberman and Wang, 2005). Moreover, APT measures
the risk associated to the systematic factors that affects the returns on assets and
determines whether they are priced into stock market returns (Maysami, et al., 2004).
According to Hubana (2013), cointegration is the basis of the statistical arbitrage

concept. Investigating the cointegration between stock markets is beneficial to strategic
investors whose main investment concern is to obtain the highest returns. A higher degree
46
of cointegration between two stock markets means that investors would then have better
arbitrage opportunities to buy and sell assets assuming that one market holds underpriced
assets. Furthermore, if two asset prices are cointegrated, it means that the spread between
the prices always returns back to its mean value. It does not mean that it has a constant
direction every trading day (Hubana, 2013).
3. 2. Conceptual Framework
This section will illustrate how existing theories and its application are relevant in
this study. It shows a diagrammatic representation of the linkages between the variables
used. As this study attempts to obtain the effects of the presence of a formalized futures
exchange on the underlying equity market, the conceptual framework illustrates the link
in the following way:
FIGURE 1. Schematic Diagram.

(ASIAN INDICES)
INTRODUCTION OF
INDEX FUTURES
C
DETERMINANTS
T
∙ Dividend Yield
∙ Exchange Rate
∙ Interest Rate
VOLATILITY ∙ Inflation Rate
∙ World Market
DERIVATIVES Index
∙ Market Sentiment
∙ Information
Shocks
APPLICATION
∙ Arbitrage
∙ Hedging
∙ Speculation
∙ Liquidity
∙ Price discovery EQUITY MARKET
∙ Information
asymmetry
∙ Market efficiency STOCK MARKET INDEX
47
The presence of a futures exchange can be dictated by multiple externalities, such
as the need to increase the sophistication of the domestic country’s financial markets,
political pressure, international pressure, or the desire to fuel economic growth. In theory,
it would improve market efficiency; however, actual studies have shown mixed results.
Previous studies, such as those by Sakthivel & Kamaiah (2011), and Kasman & Kasman
(2007), would indicate that there is a statistically significant negative relationship between
the presence of a futures exchange and stock market volatility. Previous researchers have
justified this effect by saying that the presence of an organized futures exchange improves
market efficiency by absorbing speculative activity, as well as mitigating information
asymmetries. Other researches, such as those by Kang & Yoon (2007) would indicate that
stock market volatility is further induced by the presence of a futures exchange. This is
often attributed to the manipulation of the underlying market that can yield large profits
for the speculators, thereby providing incentives to do so. Furthermore, it empowers them
as it may provide the tools to further fuel their speculative activities.
Meanwhile, stock market volatility is dictated by quantitative externalities, such

as but not limited to dividend yield, interest rate, exchange rate, inflation rate and the
movement of world market index (Caner & Onder, 2005), and qualitative externalities
such as information shocks and ongoing market sentiment (Lee, Jiang, & Indro, 2002).
The interplay between these factors cause the inherent volatility of financial markets.
While speculators prefer volatile asset prices, since it enhances their profits, it would
negatively affect risk-averse investors, corporate capital investment decisions, as well as
leverage and consumption patterns (Sakthivel & Kamaiah, 2011).
Due to the lack of depth within the Philippine financial markets, conducting an
empirical study on derivatives markets within the Philippines would be unfeasible.
Hence, the researchers would employ other financial markets within the region. These
financial markets, due to their proximity to the Philippines, demographic similarities, and
economic ties, are most likely to emulate the Philippine setting. Further supporting this
claim would
48
be the study of Janor & Ali (2007), which found that the PSE is cointegrated with the
other financial markets within ASEAN, suggesting that these markets are fundamentally
similar, despite superficial differences. Furthermore, the study of Rufino (2014) also
found that ASEAN+3 currencies share a long-run equilibrium relationship, which would
show that the economies within this region share multiple economic linkages, not just
interrelated through their financial markets.
3. 3. Operational Framework
As what has been established, the researchers will be analyzing the impact of
index futures on spot market volatility, as quantified using the GARCH model.
Thereafter, they will employ the cointegration test to see whether the Philippine financial
market moves together, in the long-run, with the other economies in the Asian region. By
doing so, they will be able to say whether or not it will be feasible and recommendable
for the Philippines to introduce the formalized derivatives exchange to further unleash its
maximum growth in the financial sector as well as the economy as a whole. Finally, this
section discusses the definitions and the importance of the variables that will be used in
this study. Table 1 presents the a-priori expectations of this study.
TABLE 1. Summary of A-Priori Expectations.
Dependent Variable: Stock Market Volatility
Independe A-Priori Economic Justification

nt Expectation
Variable
Presence of (-) The presence of a futures exchange decreases stock

a futures market volatility by increasing market efficiency,
exchange and improving information flow (Sakthiviel &
Kamaiah, 2011).
Unexpect (+) The introduction of new substantial information

ed cannot be predicted, and as such, will induce
componen volatility (Bessembinder & Seguin, 1992).
ts
Expected (-) The trading with no information shocks within a
components futures exchange will stabilize the volatility within
a market (Bessembinder & Seguin, 1992).
49
Stock Market Volatility. The volatility of the underlying stock market will be
estimated by the GARCH model. Specifically, this is the volatility of stock market
returns, as proxied by the domestic stock market index. The domestic stock market index
is used as the proxy for the overall market, as it is assumed to be the representative value
of the overall stock market. Therefore, it will reveal the trends exhibited within the
market.
Futures Exchange. The researchers will employ the presence of an organized

futures exchange as one of the main independent variable. This is denoted by a dummy
variable, wherein the variable would have a value of 1 if a futures market is present, and
0 otherwise. This would mirror the methodology of previous studies mentioned in the
literature review, as this would clearly describe the characteristics of the model.
GARCH Model. The Generalized Autoregressive Conditional Heteroskedasticity

model is a model that is used to quantify the inherent volatility within a financial market.
It would assess the values in the data, and then capture the conditional heteroskedasticity,
or volatility, within. It is known as conditional heteroskedasticity since the random
movements associated with the volatility have some trigger mechanism associated with
investor sentiment. While the GARCH model has multiple variations, the specification of
GARCH will be dictated by specification tests unless otherwise stated, thereby improving
model fit and increasing the efficiency and robustness of the model.
Expected and Unexpected Components. According to Bessembinder & Seguin

(1992), futures trading activity can be decomposed into two main categories: expected
components and unexpected components. This can be done by using econometric models
designed to efficiently predict the stochastic disturbance term then robustly decompose
them into its constituent parts. Unexpected components would represent the trading
activity within the market in response to an information shock, wherein information
shocks refer to new information presented to the market that would cause a significant
change in the underlying market. On the other hand, expected components would
represent the day-to-day trading activity within a market under no new significant
information. To
50
proxy for the trading activity within a futures exchange, as with the study of
Bessembinder & Seguin (1992), the proponents will use Open Interest and the Total
Trading Volume. Trading Volume refers to the number of contracts traded on any given
day, while Open Interest refers to the total number of the open futures contracts within a
market on a given day. As Trading Volume measures how many contracts are traded, it
gives an indicator on the amount of activity; Open Interest, on the other hand, measures
the total number of open futures contracts, lending itself to become a proxy of market
size, development and depth (Bessembinder & Seguin, 1992; Chetchatree, 2011).
Furthermore, the distinction of futures activity and open interest can also be viewed as to
the type of market player that uses them; larger open interest values may indicate that a
larger proportion of hedgers use the market, as these contracts were left open;
meanwhile, high trading volumes relative to the open interest indicate that those
contracts were used to speculate, as speculators and arbitrageurs maximize the price
changes and take advantage of arbitrage opportunities within a particular trading day
(Bessembinder, Chan, & Seguin, 1996).
51
CHAPTER 4
RESEARCH METHODOLOGY
This chapter introduces the specifics of the datasets and the models crucial to the
attainment of the researchers’ objectives. Firstly, the proponents will employ multiple
econometric models on the Southeast and East Asian financial markets to determine the
effect of the introduction of a futures exchange, as well as futures trading activity on the
spot market volatility, thereby achieving their first objective. Once the true relationship
has been determined, a long-run cointegration test between the equity markets of these
economies and that of the Philippines shall be employed. By doing so, this will show that
financial markets within the Asian region have long-run relationship; thus, the researchers
will achieve their second objective. Finally, by conducting these steps, the researchers
will be able to provide possible implications on the findings of the empirical tests.
4. 1. Decision Tree Map

The decision tree map provides a graphical representation of the author’s process
flow, on a per-country basis. It contains a brief overview of the researchers’ methodology,
with each step being detailed in succeeding sections. As such, including a decision tree
enables the proponents to easily explain the succession of steps within the study.
The map, as shown in Figure 2, begins with obtaining data, wherein the
researchers will collect data from the aforementioned databases; while the researchers
are assuming the data is accurate, preliminary checks will be conducted to ensure that
the data accurately represents actual market events. After collecting the data, the
GARCH model is then used to quantify the volatility—the exact process of GARCH will
be explained further in latter sections. Once the volatility has been quantified, the
relationship between the introduction of a futures exchange and volatility is then
analyzed. The ARIMA model is then used to decompose trading activity, and its
relationship with volatility is also analyzed. Moreover,
52
this relationship is crucial: a significant relationship, regardless of whether it is positive or

negative, will indicate that futures exchanges do affect volatility. Therefore, a long-run
cointegration test will be conducted to see if these effects can apply within the Philippine
context. An insignificant relationship will indicate that the effect is uncertain. If this is the
case, a long-run cointegration test will still be conducted to see if the Philippine market
has similar market characteristics. A positive long-run relationship will indicate that both
markets move in the same direction; with a negative relationship indicating otherwise.
4. 2. Data Description and Collection Method
Macro-level data, with a daily periodicity, will be collected for the economies
involved within the study. The variables to be collected are the following: (1) the main
stock market index for each country; (2) the open interest for index futures within that
particular market; (3) the volume of contracts traded and finally, (4) the date of inception
of the domestic futures exchange. The time period for each country will obviously differ
due to the different listing dates of a futures exchange. As the researchers are attempting
to measure the volatility within the underlying market, a daily periodicity will be used for
all tests. Hence, the researchers will be able to get the actual effects of futures trading, as
well as create results which will have the most relevant impact on actual financial
markets.
For the first estimation procedure, which quantifies the effects on volatility of
futures listing, the authors will analyze only five years pre- and post-introduction of
futures exchange, as specified in Table 2; therefore, the sample period will consist of ten
(10) years with daily frequency of data, following Gulen and Mayheew (2000). For the
second estimation procedure, which measures the volatility effects of futures trading
activity, the researchers will only be using the sample period from January 1, 2010 to
December 31, 2015 and thus, the sample period will only be comprised of five years with
daily frequency of data. Finally, the sample period for the long-run cointegration test will
start from January 1, 2005 until December 31, 2015 with a daily frequency.
53
Yes
Run the data and ascertain
FIGURE 2. Decision Tree the effect of futures
Map. introduction in spot market
volatility
Quantify stock index

return volatility
Obtain data via through GARCH Decompose open interest
Bloomberg Terminal family models into expected and
unexpected
components
Ascertain the
relationship between
components and volatility The effects of a
through GARCH models futures exchange on
volatility is uncertain
No (–)
Significant
effects? What is the
Yes
relationship? (+)
underlying markets
Futures trading
Futures trading
increases volatility in increases volatility in
underlying markets
Conduct long-run hold to true in the

cointegration with the
The observed effects will be Philippines
Philippines more likely to relationship?
Yes
NoThe observed effects
(+)
Presence of long-run
may not hold to true
in the Philippines
54
Furthermore, it is important to note that each country will be tested and analyzed in a
separate time series regression so as to prevent any untoward bias with respect to futures
exchanges established at earlier or later dates.
To maximize the relatability of the data with that of the Philippine domestic
market, the researchers will utilize a dataset comprised of countries within the same
geographic region. These economies are not only among the Philippines’ largest and
longest trading partners (Philippine Statistics Authority, 2015), but are also subjected to
similar demographic, geopolitical, and economic forces (Fratzscher, 2006). However, to
conduct an effective study, the country must also have an operational futures exchange;
otherwise, it will not have any data relevant to the study and cannot be used. As such, the
countries, and the underlying stock index to be analyzed, shall be: (1) Singapore (STI);
(2) Malaysia (KLCI); (3) Indonesia (JCI); (4) Thailand (SET); (5) Hong Kong, China
(HSI); (6) Shanghai, China (SHCOMP); (7) Japan (NKY); and (8) South Korea (KOSPI).
Despite Shanghai and Hong Kong being under the sovereignty of the People’s Republic
of China, the difference in economic systems require the researchers to analyze both
markets. As mentioned in previous chapters, the dataset will contain multiple time
periods, due to the different incorporation dates in Table 2.
TABLE 2. Period Before and After the Introduction of Futures Exchange.
Market Establishment Date Period before Period after
Singapore December 1, 1999 December 1, 1994 December 1, 2004

(STI)
Malaysia December 15, 1995 December 15, 1990 December 15, 2000
(KLCI)
Indonesia April 6, 2010 April 6, 2005 April 6, 2015

(JCI)
Thailand May 17, 2004 May 17, 1999 May 17, 2009
(SET)
55
Hong Kong May 6, 1986 May 6, 1981 May 6, 1991

(HSI)
Shanghai January 2, 1998 January 2, 1993 January 2, 2003

(SHCOMP)
Japan September 3, 1988 September 3, 1983 September 3, 1993

(NKY)
South May 3, 1996 May 3, 1991 May 3, 2001

Korea
(KOSPI)
From this dataset, the researchers will utilize multiple mathematical models, such
as the GARCH, to quantify volatility of stock market returns within these indices. Stock
market returns, will be classified as the continuous return, rather than discrete returns, to
ensure that the results are as accurate as possible. The stock market return will be given
using the following equation:
�௜� = lnܲ�
ܲ�−ଵ
where �௜� is the return on security i in period t, ܲ� is the closing price of security i on day
t, and ܲ�−ଵis the closing price of security i on day t-1. The data for the stock indices of
different equity markets, open interest, as well as contract volume will be obtained from
Bloomberg Professional Service. Furthermore, any gaps in the data will be obtained from
the website of the country’s stock exchange or from the country’s respective news sites.
4. 3. Estimation Procedure
In line with the objectives of this study, the researchers will be using different
econometric procedures to estimate the volatility of the stock index of a particular
country at a given time period. As per Siopsis & Lyroudi (2007) and Sakthiviel &
Kamiah (2011), the initial step is to model the conditional volatility by dividing the data
sample into two
56
sub-periods: period before and after the establishment of futures exchange in the financial
system of a country. Since this study deals with time series, it is also imperative, prior to
estimating the models, to obtain the unit root properties of the data per market and this
can be done through the Augmented Dicky-Fuller (ADF) Test which determines whether
time series is stationary or nonstationary, and the Phillips Perron (PP) Test which adjusts
the t-statistic of the coefficient as well as accounts the serial correlation. In choosing the
optimal lag length for the variables included in the model, the researchers will use the
following to aid their decision: Akaike Information Criterion (AIC), Schwarz Criterion
(SC), Final Prediction Error (FPE), Likelihood Ratio (LR) Criterion, as well as Hannan
Quinn (H-Q) Information Criterion (Gujarti & Porter, 2009). Thereafter, the ARCH and
GARCH models will be used to “capture the persistence of the volatility” within the
equity market of a country. Further, to determine whether long-run equilibrium
relationship exists within Asian financial markets, the Engle-Granger and Johansen
cointegration shall be used (Gujarati & Porter, 2009).
The use of multiple countries within the dataset is of paramount importance. By

doing so, the researchers are able to see the effects of futures trading across different
economic systems, degrees of economic regulation, and level of government intervention.
Hence, they will be able to show a more complete view of the effects of futures trading.
However, in the event of a conflict, the researchers will rely upon the findings within
Malaysia to make meaningful recommendations, as the study of El-Wassal (2005) found
that the Philippine and Malaysian financial markets not only share a high degree of
correlation, but also a causal relationship.
As each country’s futures exchange was established on different dates, each time
series regression will be conducted using different time periods. Moreover, this works in
the favor of the researchers, as it will illustrate whether the relationship could hold true,
regardless of time period. It would also show the robustness of the relationship, given that
57
each time period is marked with different local and international economic, financial, and
geopolitical events (Dong & Zhang, 2010).
As shown in the decision tree above, the researchers will first attempt to ascertain
the level of volatility exhibited by the stock market before and after the introduction of
the futures exchange. The relationship between these two variables will be conducted via
a regression model, which will illustrate how the presence of a futures exchange affects
volatility of stock market returns. Next, a second regression will be conducted, wherein
the effects of futures trading, as proxied by open interest and trading volume, on stock
market return volatility will be shown. Moreover, this is the regression wherein expected
and unexpected components of futures trading, as decomposed by the ARIMA model,
will be used. Lastly, the Johansen cointegration test will be conducted to see if there is
long run relationship among the Asian economies’ and the Philippines’ market indices.
4. 3. 1. The Conditional Volatility Models
Ray and Panda (2011) noted that the two main purposes of using the conditional
volatility models are: (1) the linear time series models are not suitable because it yields
poor forecasts of the predictors and that if fails to simultaneously model both the
forecasts and the volatility, measured by the variance, due to the varying nature of the
latter; (2) the Classical Linear Regression Model (CLRM) assumes that the residuals
(also known as error terms) are constant. Therefore, a crucial implication of this is that
the standard errors would be incorrectly estimated if the error terms are assumed to be
homoscedastic, but in fact, they are heteroskedastic (Ray & Panda, 2011).
It is important to note that in financial time series studies, researchers use model
that relaxes these assumptions such as that of Engle (1982) who proposed a specification
which is the Autoregressive Conditional Heteroscedastic (ARCH) model in response to
these shortcomings. One of the salient features of ARCH model is that it well captures
the volatility. Going back to Ray and Panda (2011), they pointed out that the “current
level of volatility tends to be positively correlated with its level during the immediate
preceding
58
periods”. Thus, nonlinear models such as GARCH family models would be appropriate
to use in this study.
4. 3. 2. ARCH Model
The ARCH model, as proposed by Engel (1982), relaxes some of the assumptions
of the CLRM and this model is also recurring in the literature. The conditional mean of
the data sample is determined using ARMA(p,q) models as well as through the AIC and
BIC criterions (Siopsis & Lyroudi, 2007). Awan and Rafique (2013) also noted that the
variance of the error terms for a given period is dependent on the variances of the error
terms in the preceding period. In OLS, this would be invalid because the test of
hypothesis for the regression coefficients and its respective standard errors will be
improperly and inaccurately estimated. Therefore, the ARCH and the GARCH models
do not consider heteroscedasticity as a violation of the assumption but rather, it
incorporates the variances within the model (Engle, 2001; Ray & Panda, 2011; Awan &
Rafique, 2013).
According to Ray and Panda (2011), creating an ARCH model is composed of 3

steps. First, an econometric model must be specified such as that of the ARMA(p,q)
model for the returns so as to eliminate the covariance (i.e. “linear dependence”) in the
dataset and appropriately use the residuals of the model to identify the ARCH effects.
Second, the order of the ARCH must be specified and run the regression through a
statistical software. In this study, the researchers will be using the Stata and Gretl
softwares. Lastly, evaluate the fitted ARCH model and refine it if deemed necessary until
the researchers identify the best variation that captures the nuances of the data.
4. 3. 3. Volatility Effect of Futures Introduction through GARCH Models
To complete the first objective of this study, this section introduces the GARCH
model so as to affirm whether the presences of a futures exchange has an impact on the
underlying spot market volatility. The GARCH models are essentially comparable to
ARCH models such that the only difference between the two models is that GARCH
59
models incorporate moving average lags. For example, a model denoted as a GARCH
(1,1) model assumes that there is one autoregressive lag, or more commonly denoted as
ARCH term, and one moving average lag, or what researchers call as GARCH terms.
Hence, a GARCH model exhibits the following notation: GARCH (p, q) model, where p
indicates the number of ARCH parameters, and q as the number of GARCH parameters
(Engle, 2001).
The GARCH (1, 1) model is considered to be the most basic model of the
GARCH family of volatility models. According to Engle (2001), the GARCH (1,1) is the
simplest and most robust model. Moreover, the researchers have set ARCH(1), the first
lag of the squared error and GARCH(1), the first lag of the conditional variance as these
parameters are able to sufficiently capture the effects of volatility clustering in financial
time series datasets (Siopis & Lyroudi, 2007). However, since the simple GARCH model
ignores the direction of returns (i.e. asymmetric response of volatility to news), the
researchers have also used the extensions of the GARCH model, in particular the
EGARCH as well as GJR GARCH model to incorporate these (Nelson, 1991; Glosten,
Jagannathan, and Runkle, 1993). Following Bollerslev (1986) and Siopis and Lyroudi
(2007), the GARCH model that the researchers will first use is shown in Equation (1)
below:
ଶ �+ ଶ
+ ߚଵ��−ଵ� �ߛ‫ ܦ‬+ (Eq. 1)
��ଶ = �଴ + ߙଵ��−ଵ
ଶ
is the squared error term of the
where ��ଶ t is the conditional variance of the period t, ��−ଵ
ଶ
is the conditional variance of the previous period, both ߙଵ (ARCH
previous period, ��−ଵ
parameter) and ߚଵ (GARCH parameter) are the regression coefficients, and �௜� is the
unexplained error term or stochastic disturbance term. If the conditional variance, ��ଶ, is
positive this means that the coefficients in the model �଴, ߙଵ, and ߚଵ have positive values
(Siopis & Lyroudi, 2007).
The corresponding coefficients in Equation (1) are as follows: First, the coefficient
ߙଵ, which is known as news coefficient, indicates information transmission. Therefore,
an
60
increase in the coefficient ߙଵ implies that the information or news is reflected in asset
prices more quickly; otherwise, the news is slowly reflected in asset prices. The ߙଵ,
which is also known as the ARCH parameter, indicates the impact of the price changes
yesterday in today’s price changes; the higher the value means that more recent news has
a greater effect on the price change. Second, the ߚଵ coefficient or the GARCH parameter
is also known as the “persistence coefficient”; as such, an increase indicates that the old
information has a higher persistence effect on the changes in asset prices; otherwise, it
has a lower effect (Antonious et al, 1998; Siopis & Lyroudi, 2007). If the sum of ߙଵ and
ߚଵ nears one, then the presence of volatility shocks still exist in the market. Third, the
dummy
�‫ܦ‬ ,variable, corresponds to the existence of a futures exchange (value is 0 if the

country i has yet to establish a futures exchange and value is 1 if country i has already
introduced the futures exchange). If the dummy variable, ‫�ܦ‬, is found to be statistically
significant, then the introduction of futures trading has changed the volatility of the spot
market. Furthermore, as highlighted in the theoretical and empirical literature, a negative
(positive) coefficient ߛ would then confirm the stabilization (destabilization) hypothesis.
Lastly, the stochastic disturbance term, ��, is added into the model to account for the
other variables that were not incorporated in the model. Therefore, if the ARCH and
GARCH parameters of the sample are significant, then it exhibits volatility clustering
and persistence which implies that a shock in security prices will persist in subsequent
periods; otherwise, it will only last for a short period (Siopis & Lyroudi, 2007; Awan &
Rafique, 2013).
Although the GARCH has the capability to measure volatility clustering as well
as persistence, the model cannot capture the asymmetric response of volatility to
information. As such, if the data used in the study requires a much more complex model
to fully capture such peculiarities, then the researchers should use the extension of the
simple GARCH model, such as the EGARCH model proposed by Nelson (1991), the
TGARCH model of Glosten etl al. (1993), or by adjusting the ARCH and the GARCH
term (Engle, 2001). Another limitation of the GARCH model is that there nonnegative
constraints are imposed
61
on the parameters (�, ߙ ,and ߚ (to ensure that the variance remains positive. Finally,
another drawback of the GARCH(1,1) model is that the shocks may persist in one norm
and die out in another; thus, there may be a problem of estimating how long shocks
persist.
One of the extensions of the GARCH model is the EGARCH model as proposed by
Nelson (1991) as illustrated in Equation (2). The EGARCH model allows asymmetric
responses of the conditional volatility to negative and positive shocks (Siopis & Lyroudi,
2007; Bohl, et al., 2015).
��−1| + ߙଶ ቀ��−1
logሺ��ଶሻ = �଴ + ߙଵ | �
�−1 ��−1ቁ + ߚଵlogሺ��−ଵ
ଶ �+
� �ߛ‫ ܦ‬+ ሻ (Eq. 2)
where �‫� ݋‬ሺ��ଶሻ is the logarithmic conditional volatility. Since variance was
transformed into its log form, the conditional variance will remain to be positive even if
the parameters are negative. The coefficient ߙଵ captures the asymmetric effect, while the
coefficient ߙଶ is the magnitude effect or known as the “leverage effect” which refers to
the inverse relationship between security return and the change in volatility (Aït-Sahalia,
Fan, & Li, 2013). As such, an unexpected decline in the security return would lead to
higher volatility than an unexpected increase in security return, and the EGARCH model
is able to capture this scenario. According to Bohl, et al. (2015), if ߙଶ is negative and
statistically significant, then negative shocks have a greater impact on volatility than
positive shocks; otherwise, negative shocks have lesser impact than positive shocks.
Furthermore, the coefficient ߙଵ
measures the persistence effect, just like the ߚଵ coefficient in the simple GARCH but in
this model, its value is in its logarithmic form. ‫ �ܦ‬is the dummy variable in order to test
for the impact of the introduction of a futures exchange and �� is the stochastic
disturbance term. One of the crucial advantages of the EGARCH is that it has a larger
“asymmetric news impact curve” given that its conditional variance is exponential
(Engle & Ng, 1993; Siopis & Lyroudi, 2007).
62
The last and another extension of the GARCH model is the threshold GARCH
(TGARCH or the GJR-GARCH) as used by Glosten, Jagannathan, and Runkle (1993),
and this is shown in Equation (3) below. Engle and Ng (1993) argued that due to the
leverage effect, the GARCH model previously discussed may have underestimated the
degree of volatility responding to bad news and may have overestimated those responding
to positive news (Kang & Yoon, 2007). Therefore, the TGARCH or the GJR-GARCH
addresses this issue by capturing the movements of the negative shocks by determining
the conditional volatility based on the sign of the prior lagged values (Tsay, 2005).
��ଶ = �଴ + ߙଵ��−ଵ
ଶ
+ ߙଶ��−ଵ
ଶ
ߜ−�ଵ + ߚଵ��−ଵ
ଶ � +
� �ߛ‫ܦ‬ + (Eq. 3)
௜ߜ ,ଶߙ ,ଵߙ where, and ߚଵare positive parameters which have almost similar properties as
GARCH model in Equation (1). ߚଵ now measures the leverage effect. Moreover, the main
difference in the TGARCH or the GJR-GARCH model is the presence of ߜ� in the
lagged square error, where ߜ−�ଵ= 1 if �� is negative; whereas, 0�= ߜ if otherwise). This
allows good news (�� > 0ሻ and bad news (�� < 0ሻ to have different impacts on the
conditional variance. In this instance, good news has only ߙଵ impact on volatility, while
bad news has ߙଵ + ߙଶ effect on the volatility. Furthermore, if ߙଶ is zero then the
GJR-GARCH model can be considered as a simple GARCH model. As per Alexander
(2001), the best GARCH model is when the returns no longer have significant
autoregressive heteroscedasticity after standardizing by its conditional volatility.
4. 3. 4. Impact of Futures Trading Activity
As previously stated, the researchers will use the model of Bessembinder &
Seguin (1992) as a foundation to illustrate the effects of futures trading on underlying
volatility. As defined by Bessembinder & Seguin (1992), the expected component is
composed of day-to-day trading under no information shock. Meanwhile, unexpected
component is composed of sudden trading in response to an information shock. As
defined previously in the paper, information shocks are composed of burst of sudden
material information
63
that would cause significant changes to the value of an asset. The expected and
unexpected components will be derived from open interest and futures market trading
volume within the futures exchange of a specific country. Open interest is the total
number of open futures contracts, or active futures contracts, for a given trading day.
These components will be derived from the open interest as it will signify the
characteristics and strength of futures trading within a day. From this data, the
researchers will be able to decompose the trading activity into expected and unexpected
components. As these variables are based upon the open interest and futures exchange
turnover of a specific country, its relationship with stock market volatility will be
ascertained by a separate time series regression, as these variables will only become
available upon the establishment of the futures exchange.
To ensure that the growth in volume over time due to market maturity does not
bias the characteristics of the dataset, a de-trended time series is constructed by
subtracting the 100-day moving average from the time series per country. To decompose
the time series into the desired variables, the ARIMA (p, d, q) model is used. ARIMA (p,
d, q), wherein p, d, and q represent the autoregressive order, the degree of differencing,
as well as the order of the moving average model. In the study of Bessembinder &
Seguin (1992), they used the ARIMA (0, 1, 10) model; however, the researchers will
employ specification tests to determine the appropriate autoregressive order, degree of
differencing, and order of the moving average model.
In most econometric studies, ARIMA (p, d, q) is often used for its forecasting
ability, as it decomposes the error to ascertain the autoregressive heterogeneities that is
then used to forecast future values. These autoregressive heterogeneities are captured
within the stochastic disturbance term, or the error, and are then used to forecast future
values. While other econometric models are able to do this, ARIMA is notable in its
ability to do this efficiently and robustly. It is for this particular reason that the
researchers have selected the ARIMA model for decomposition.
��+ଵ = ߙଵ + ߙଶ�� + ߙଷ��−ଵ + ⋯ + ߙ+�ଵ��−� + � (Eq. 4)
64
As shown in the model in Equation (4) above, the ARIMA model is dependent on
previous values, albeit to varying degrees, as well as the stochastic disturbance term. As
mentioned earlier, the model’s ability to efficiently and robustly capture the stochastic
disturbance is the primary reason for selecting the ARIMA model. Once the model has
accurately predicted the error term, the researchers can then decompose it into its
constituent components, namely the trend and idiosyncratic component, or the expected
and unexpected components that Bessembinder & Seguin (1992) were referring to in
their study. Seasonality, while a strong component of most datasets and a significant
component of the error in most cases, is less of a concern in financial datasets due to the
random walk that efficient financial markets take in the long run. As the markets in the
researchers’ dataset have been proven to be efficient in previous studies, the researchers
will assume that these markets are efficient and do follow a random walk in the long run.
However, short-term trends may still appear in efficient markets, as postulated by the
Efficient Market Hypothesis; these trends, while short-lived, can still appear and will
construe the expected component of the study. In spite of this assumption, the
researchers will still test for possible seasonality within the data.
An alternative model which can be used in the decomposition would be the UCM
model, or the unobservable components model. This model aims to capture unobservable
components of a dataset, which can be construed as the trend and idiosyncratic
component as well. In large datasets, the results of the UCM model and the ARIMA
model would be almost identical, as large datasets would provide either model with
enough data points to accurately predict the error. However, as ARIMA is more efficient
and robust, it shall be the model of choice for this study, following Bessembinder &
Seguin (1992).
��ଶ = �଴ + ߙଵ��−ଵ
ଶ
+ ߙଶ��−ଵ�‫ܷ݊��݋ܸ݌‬ସ‫ �݋ܸ݌�ܧ‬+ ߙଷߙ + ଶ
�� + �ܱ‫ �ܱ݌�ܧ଺ܷ݊��݌‬+ ߙହߙ + (Eq. 5)

65
To see how futures trading affect the volatility of the spot market, the researchers
will use the decomposed variables. The decomposed variables are placed into the
GARCH model, which will indicate how both “background trading” and trading under
shock occurs. This relationship is explained by Equation (5), where the expected and
unexpected components of volume are denoted as ExpVol and UnexpVol, respectively,
and the expected and unexpected components of open interest are denoted as ExpOI and
UnexpOI:
Despite GARCH being used by many researchers to model financial datasets, it

too has its limitations. GARCH models are better equipped to estimate results of
relatively stable markets (Bollerslev, 1986); although it is often used to analyze
conditional volatilities in time-series financial datasets, it is unable to accurately capture
the effects of abnormal or irregular market conditions and unanticipated events (e.g.
market crashes, political uncertainty, etc.). Moreover, the GARCH (p, q) model can also
include additional lag terms since higher-order models are often useful when the data has
long sample period and has a higher frequency (Engle, 2001). Engle (2001) further noted
that those models with additional lags would allow both fast and slow decay of
information. As an example, a single lag on the squared return and variance would mean
going back one period in time (i.e. yesterday); if there are two or more lags, then more
weight is given to the previous squared return or variance. Thus, a post-estimation
testing, such as those employing the information criterion, is appropriate to identify the
best-fitting GARCH.
4. 3. 5. Johansen Multivariate Cointegration Test
As per Gujarati and Porter (2009), cointegration is a property of two or more non
stationarity time series to have a long-run equilibrium relationship. A long-run
equilibrium relationship can be interpreted as a relationship wherein both series will
exhibit variances consistent with their relationship; although exogenous market shocks
may cause these relationships to temporarily “break”, cointegrated series will return to
their equilibrium state and continue to “move together” when taken from a long-run
perspective. Unlike obtaining the covariance and correlation, which would indicate the
relationship between
66
the series, a long-run cointegration test shows the long-run relationship, and a propensity
for the data to return to this equilibrium state (Gujarati & Porter, 2009). As this
relationship can be assumed to have been brought about by multiple endogenous factors
that cause the series to react in a similar fashion, the researchers will use this test in order
to show that the introduction of a futures exchange in external markets may have similar
results here in domestic markets.
Johansen Cointegration Test is a generalized multivariate form of the Augmented

Dickey Fuller Test. Sjo (2008) suggested that this is the most desirable cointegration test
as it has complete statistical properties. However, it may have some specification errors
given a limited sample due to asymptotic properties. Moreover, there are two more initial
tests needed which are the Trace Test and the Max Eigenvalue Test in order to know the
significance of the ranks (Gujarati & Porter, 2009).
The maximum eigenvalue test determines if the biggest eigenvalue is zero relative
to the alternative largest eigenvalue which is also zero. Cointegration do not exist if the
matrix rank (Π) is zero and the biggest eigenvalue is zero. It only exists in some vectors if
the biggest eigenvalue is nonzero and the matrix rank (Π) is at least one. On the other
hand, in the trace test, cointegration does not exist if the matrix rank (Π) = �଴; whereas,
it exists if �଴ < (Π) ≤ n, where n is the maximum number of vectors (Dwyer, 2004).
To achieve the second objective of this study, it is imperative to test whether the
Philippine’ financial market is cointegrated with its counterparts in ASEAN-5 plus 3.
Before employing the 2 different statistical tools mentioned before, the series being tested
should be integrated of the same order as per Janor and Ali (2007). Thereafter, the model
shown in Equation (6) below will be used to determine if a long-run relationship between
two stock market indices:
ln ߙ +
ln(ܲ�௝�ܲ) ଵ ௜
଴ߙ = ( ) + �� (Eq. 6)
67
where the two stock market indices are represented by i and j at time t. The cointegration
between the Philippines and its counterparts in the Asian region in the long-run implies a
linear relationship between the natural logarithms of the stock indices prices. Given that
this study is considering more than two variable series due to having a number of
countries involved, Equation (6) as shown above will be applied to a multivariate
cointegration as it would be more appropriate. By doing so, the researchers will be able
to attain the third objective of this study.
68
CHAPTER 5
PRESENTATION AND ANALYSIS OF RESULTS
This chapter discusses the data analysis and findings in accordance to the decision
tree shown in the previous chapter. The dataset used in this study is composed of market
indices for eight financial markets in the Southeast and East Asian region (Singapore,
Malaysia, Indonesia, Thailand, Hong Kong, Shanghai, Japan, South Korea, as well as the
Philippines) and seven index futures, same as the economies stated before except for the
Philippines as the latter has yet to establish a futures market domestically. The dataset is
organized into time series as each has its own unique data points with the exception of the
cointegration test as they used multivariate method. The lists of index futures and market
indices were adopted based on the availability of the Bloomberg Professional Services.
In line with the first objective of this study, the GARCH family models was used
to see the volatility effects of futures listing in the spot market through the inclusion of
dummy variables (1 for post-period futures listing; otherwise, value is 0). The dataset
used in this particular testing is in daily frequency and continuous returns were used to
assess the conditional volatility. Thereafter, futures trading activity from the years 2010
to 2015 was decomposed, using the ARIMA (p,d,q) model, to analyze the effects of
futures trading on the volatility of its underlying market.
To complete the second and third objectives of this study, a multivariate Johansen
cointegration test was employed to identify whether or not the Philippine equity market
manifests a long-run relationship with the equity market of the eight Southeast and East
Asian economies using a 10-year daily dataset of market index returns. The results of the
multivariate cointegration test determined the applicability of the study findings in the
domestic market. After conducting all empirical tests, the researchers then determined the
actual relationship between return volatility and futures listing and trading, thereby
allowing the proper recommendations to be made.
69
5. 1. Volatility Effects of Futures Introduction through GARCH Models

5. 1. 1. Descriptive Statistics
To provide an overview of the dataset used, the researchers employed the use of
descriptive statistics. As presented in Figure 3 below, it can be observed that the volatility
clustering for the eight (8) market indices are quite evident. Large changes in returns are
subsequently followed by large changes as well, and that the small changes in returns
tend to be followed by small changes. Hence, it should be noted that volatility is
persistent in the span of ten years, which is not unusual for daily financial time series
data.
FIGURE 3. Daily Returns of 8 Asian Market Indices, Pre and Post Futures Listing.
.
1.
1
IC
.
1
I
.
5
L
2. 0
.
5
-
0 e u
0 0 2
. n t
r
. J 0
- r
0 e 5
1
u _ r
. n 0
K _
t
5 - r .
1
.
-
1.
-
.
01, 2004 DATE_STI 01, 2000 DATE_KLCI

Jan 01, 1994 Jan 01, 1996 Jan 01, Jan 01, 1990 Jan 01, 1992 Jan 01, Jan 01, 2005 Jan 01, 2010 Jan 01, 2015
1998 Jan 01, 2000 Jan 01, 2002 Jan 1994 Jan 01, 1996 Jan 01, 1998 Jan DATE_JCI
P
.
- 1
0 M
.
1 O
1 .
0
C
. -
IS
H 1
5 2
.
. S
0
-
H -
.
_
2
_ 3
0 n
.
.
n r
-
5 -
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u
0 4
u t
.
.
t
- e
-
1 e r
3
. r
1 .
-
.
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1 .
Jan 01, 2000Jan 01, 2005Jan 01, 2010 Jul 01, 1988 Jan 01, 1991 DATE_HSI DATE_SHCOMP
DATE_SET Jan 01, 1993 Jul 01, 1995 Jan 01, 1998
Jan 01, 1981 Jul 01, 1983 Jan 01, 1986 Jul 01, 2000 Jan 01, 2003
IP
0
S
.
O
1
0
. K
5
0
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-
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.
Jul 01, 1983 Jan 01, 1986 Jul 01, 1988 Jan 01, 1991 Jul 01, 1993 Jan 01, 1996
Jan 01, 1991 Jul 01, 1993 DATE_NKY Jul 01, 1998 Jan 01, 2001 DATE_KOSPI
Note: The introduction of futures market is indicated by the dashed line.
Table 3, on other hand, summarizes the key statistics for the 8 time series datasets
used in this study. The sample mean of returns for each country is very small, while the
standard deviation is higher. Moreover, the sample returns per country does not subscribe
70
to the assumption of normal distribution given a high measure of skewness and excess
kurtosis. For a normal distribution to hold, the coefficient of skewness and kurtosis should
be 0 and 3, respectively (Gujarati & Porter, 2008; Kang & Yoon, 2007). Though it should
be noted that this is not unusual for financial time series. The Ljung-Box portmanteau
statistic of Q(20) for all economies suggest that the returns are serially correlated as they
are significant at the 1% level. Furthermore, these findings imply that the following exist
within the data: non-normality, volatility clustering in market index returns, and serial
correlation; although these are acceptable given the large amount of data.
5. 1. 2. Diagnostic Testing for GARCH Models
Statistical tools were used to test for the existence of heteroskedasticity for the sample
period on a per country basis. Following the empirical procedure for testing of ARCH
effects of Gujarati and Porter (2009), the authors inspected first the correlogram of
squared residuals. Based on that, it can be inferred that there is heteroskedasticity in the
returns for the sample period, which is expected since conditional heteroskedasticity is
often observed in stock prices. To further find stronger evidence, they also employed the
ARCH-Lagrange multiplier test, a more formal and direct way of testing the presence of
ARCH effects. According to the results in Appendix 1.3, the p-values for all economies
are significant which implies that the returns data exhibit conditional heteroskedasticity.
By all accounts, they can thus conclude that there is a dynamic conditional variance
across the sample of eight financial markets.
5. 1. 3. Analysis of GARCH Model Results
After proving the existence of ARCH effects, the researchers examined the volatility of
the returns of the 8 market indices in Southeast and East Asia. The GARCH family
models used in this study, in accordance to the methodology, are the following :
GARCH(1,1), EGARCH(1,1) and GJR-GARCH(1,1) in accordance to Verbeek’s (2004)
study indicating that the GARCH(1,1) is the most robust model, as well as the
researchers’ post-estimation analysis. By doing so, they are able to capture the effect on
the volatility
71
TABLE 3. Summary Statistics for Daily Returns of 8 Market Indices, Pre and Post Period.
Statistics Retur Return Return Return Return Return Return Return
ns KLCI JCI SET HSI SHCOMP NKY KOSPI
STI
Observations 2508 2473 2439 2454 2472 2450 2468 2823

Mean -0.0054 0.0130 0.0660 0.0053 0.0390 0.0215 0.0337 -0.0039
Minimum -9.1535 -24.15 -10.95 -16.06 -40.54 -17.91 -16.14 -12.37
Maximum 12.873 20.817 7.623 10.577 8.8949 28.861 12.430 8.1613
SD 1.4163 1.8251 1.4446 1.5719 1.9406 2.597 1.276 1.8947
Skewness .21248 .51723 -.6708 -.6855 -4.964 1.317 -.4147 -.0328
Kurtosis 10.443 35.458 10.005 11.359 93.301 21.251 20.565 6.160
(excess) 58.08*** 1086.68*** 51.70*** 73.37*** 8500.49*** 347.10*** 317.97*** 11.75***
Jarque-Bera
Autocorrelatio
ns: Raw series 13.53 20.245*** 5.313** 1.434 7.367*** 0.960 0.9082 20.958***
p(1) 8*** 20.894*** 20.89 8.824** 8.991** 4.514* 7.906** 22.601***
p(2) 13.54 22.621*** 4** 9.980** 12.019*** 4.612 8.029** 23.723***
p(3) 5*** 23.310*** 7.472 14.13 12.053** 4.719 8.207* 23.893***
*
p(4) 28.41 23.760*** 2*** 22.354*** 13.976** 10.041* 25.032***
p(5) 6*** 38.272*** 7.564 14.48 24.018*** 36.296*** 17.162* 43.501***
p(10) 29.66 49.483*** 9.442* 0** 38.948*** 55.226*** 34.889** 53.9733**
Q(20) 3*** 14.085 15.222
32.83 30.963* 32.337**
0***
38.49
4***
56.76
2***
Note: Mean, Minimum, Maximum, and SD are expressed in percentage (%); Jarque-Bera expressed in
hundreds. *** Significant at 1%; ** Significant at 5%; * Significant at 1%.
Source: Based on the results generated by STATA 13 software.
72
of these indices through the inclusion of a dummy variable in the GARCH models for the
whole sample period of the respective indices. Moreover, it should be noted that the
dummy variable’s coefficient and sign would indicate if the introduction of futures
trading has mitigated or induced the spot market volatility, or if it remain to be the same.
TABLE 4. GARCH Model Results for Strait Times Index

(STI) Economy: Singapore
MODELS ࢽ
૙� ૚ࢻ ૛ࢻ ૚ࢼ
GARCH(1,1) 0.00007 0.11927 0.86854 0.4024

*** ***
(0.00022 1**
) (0.0093 (0.0087 (0.1744
3) 5) 9)
EGARCH(1,1) -0.0001 -0.05788 0.20714 0.98166 0.00257

7 *** *** *** (0.00398
(0.0002 (0.0073 (0.0145 (0.0028 )
1) 2) 2) 2)
GJR-GARCH(1,1) -0.0001 0.15866 -0.09181 0.87457 0.3656

*** ***
8 ***
7**
(0.0002 (0.0132 (0.0130 (0.0086 (0.1686
2) 8) 0) 9) 6)
Note: *** Significant at 1% level; ** Significant at 5% level; * Significant at 10% level.

To begin with, Table 4 shows the GARCH results for the Straits Times Index (STI) in
Singapore. The ARCH(1) parameter (ߙଵ) is equal to 0.12 and the GARCH(1) parameter
(ߚଵ) is equal to 0.87, with standard errors at approximately 0.09 for both the parameters.
Moreover, the sum of ߙଵ and ߚଵ is 0.99 which approaches unity. Hence, this implies that
shocks to the conditional variance are highly persistent. In other words, the persistence
of past volatility highly explains the current volatility of Straits Times Index (Engle &
Bollerslev, 1986). With both parameters positively significant at the 1% level, this would
also indicate that the unexpected negative and positive returns were due to the same
magnitude of the volatility. Although this would imply that the GARCH(1,1) model does
not perfectly capture the volatility asymmetry in the Singaporean equity market.
Nevertheless, its dummy variable is deemed to be positively significant at the 5% level
with a positive coefficient of 0.40. Thus, this provides an evidence that futures trading
may have induced the spot market volatility.
As for the EGARCH(1,1) model, the ߙଵ, ߙଶ and ߚଵ are -0.06, 0.21 and 0.98,
respectively. All parameters are significant at the 1% level, indicating that the news
73
parameter (ߙଵ) as well as the persistence coefficient (ߚଵ) to have implications. The sum
of ߙଵ and ߚଵ also approaches unity similar to GARCH model. Unlike the GARCH(1,1)
model, the leverage effect is added into the EGARCH model, this is to see how the
volatility is affected by the movement in the price of the market index. Since the leverage
effect (ߙଶ) is positive, then negative shocks have lesser impact than positive shocks (Bohl
et al., 2015); thus, the EGARCH model may have captured the volatility asymmetry
better due to the conditional variance being exponential. Although the dummy variable
for this particular model is positive with a coefficient of 0.002, it is insignificant.
Finally, the GJR-GARCH(1,1) shows that the ARCH and GARCH parameters are also
positively significant at the 1% level, indicating the persistence of volatility. The leverage
effect is also significant but with a negative coefficient which implies that negative
shocks have greater impact than positive shocks in contrast to the EGARCH model
(Bohl et al., 2015). Though the asymmetry ratio [ߙଵ/(ߙଵ + ߙଶሻ] for the GJR
GARCH model is higher than the EGARCH model which means that GJR-GARCH
better captures the volatility asymmetry in the returns of STI. This would later be proven
that GJR-GARCH model outperforms the other two models later on. At any rate, the
dummy variable is positively significant at 5% level, with coefficient of 0.37 which is
close to that of the GARCH model. This implies that there is a 0.37 unit increase in the
spot market volatility after the introduction of futures trading in Singapore. Thus, there is
another evidence that futures trading has induced spot market volatility in Singapore.
With two out of three similar results, it is safe to say that the introduction of futures
exchange has indeed induced volatility in Singapore’s equity market. This finding is
similar to Islam (2014), although he found that there is a positive effect on the volatility
after the establishment of a futures exchange in Singapore, he found it to be insignificant
in various windows periods. One possible explanation for the induced volatility is that
they have established their futures exchange few years after the outbreak of the Asian
74
financial crisis and thus, the market may still be undergoing the shift into a new or revised
regulatory framework for its financial system (Shamsher & Taufiq, 2007).
TABLE 5. GARCH Model Results for Kuala Lumpur Composite Index

(KLCI) Economy: Malaysia
MODELS ࢽ
૙� ૚ࢻ ૛ࢻ ૚ࢼ
GARCH(1,1) 0.0005 0.13639 0.85405 0.28632

4** *** *** **
(0.0002 (0.0102 (0.0094 (0.1345

2) 7) 1) 8)
EGARCH(1,1) 0.00042* -0.04288 0.24389 0.97809 0.01073

*** *** *** **
(0.00022)
(0.0077 (0.0150 (0.0024 (0.0049
0) 7) 9) 2)
GJR-GARCH(1,1) 0.00031 0.17509 -0.08627 0.85747 0.13310

(0.00024) *** *** *** (0.13346)
(0.0153 (0.0147 (0.0095
7) 2) 0)

Table 5, on the other hand, shows the results of the GARCH models for the Malaysian
financial market. The ARCH and GARCH parameters are 0.14 as well as 0.85,
respectively, which is very close to unity. This indicates that volatility is persistent within
the ten year range, similar to other Asian markets. Moreover, this also shows that old
information is more sustained in affecting the price of the index. The constant coefficient
is also positive and significant at the 5% level which means that there really is volatility
even if the other factors are not present. Interestingly, the dummy variable is positively
significant with coefficient of 0.29, which implies that futures trading may have propelled
volatility in the Malaysian market similar to the study of Pok and Poshakwale (2004).
The EGARCH(1,1) model shows that ߙଵ, ߙଶ and ߚଵ are significant at the 1% level. The
news coefficient indicates that recent news in the market has lesser impact on the price
changes thought it must be noted that the time frame in this particular is in the 1990s
when they have experienced significant economic growth. Whereas, the leverage effect is
positively significant and thus, positive shocks generate more volatility than negative
shocks. The dummy variable is also positively significant at 5% level, which means that
the spot market volatility has increased after the introduction of futures derivatives in the
Malaysian market.
75
GJR-GARCH(1,1) model, on the other hand, shows significant parameters at the 1%

level. The leverage effect is negatively significant, suggesting that losses have a greater
impact on volatility than gains, which is in contrast to the finding of the EGARCH
model. The asymmetry ratio is higher for the GJR-GARCH than the EGARCH; however,
the dummy variable is positive but insignificant. Moreover, the coefficient of the dummy
variable suggests that the volatility of the stock market index of Malaysia grew by 0.13
unit. Nevertheless, with two evidences of significant with positive coefficients, this would
mean that the inception of a futures exchange has induced the spot market volatility in
Malaysia, contrary to the findings of Gulen and Mayhew (2001). At any rate, this finding
corroborates the study of Pok and Posakwale (2004) in which spot market volatility was
high on the onset of futures trading. Similarly, Bacha, Abdul, and Othman (1999) found
that there are significant arbitrage opportunities in the early years of a futures contract in
which speculators may have taken advantage of. Furthermore, Bacha et al. (1999) noted
that the mispricing may be due to the “institutional inertia” caused by the uninformed
traders, lack of volume, or “inadequate supply of arbitrage capital”.
TABLE 6. GARCH Model Results for Jakarta Composite Index

(JCI) Economy: Indonesia
MODELS ࢽ
૙� ૚ࢻ ૛ࢻ ૚ࢼ
GARCH(1,1) 0.00100 0.14116 0.83201 -0.75957

*** *** *** ***
(0.0002 (0.0118 (0.0118 (0.1292

2) 2) 6) 8)
EGARCH(1,1) 0.00077 -0.10061 0.23063 0.95517 -0.03524

*** *** *** *** ***
(0.0002 (0.0115 (0.0173 (0.0050 (0.0067

2) 4) 1) 7) 9)
GJR-GARCH(1,1) 0.00076 0.19716 -0.14107 0.82782 -0.74641

*** *** *** *** ***
(0.0002 (0.0158 (0.0177 (0.0113 (0.1004

3) 4) 2) 7) 4)

The GARCH model results for the Indonesian market index are shown in Table 6 above.
The ARCH and GARCH parameters above are 0.14 and 0.83, respectively, which
approaches unity. For the news coefficient, it shows that among the ASEAN capital
markets, recent news has the greatest impact on price changes though this may be due to
76
the fact that they have the most recent dataset given that they only introduced their futures
exchange in 2010. Nonetheless, volatility shocks are still persistent, as evidenced by the
positively significant constant term. Further, the dummy variable is significant at 1% level
and the coefficient is negative, implying that futures trading may have mitigated the spot
market volatility.
The three parameters are also significant under the EGARCH(1,1) model. The leverage
effect is positively significant indicating that unanticipated price decreases are more
stabilizing than price increases. Moreover, the news and persistence coefficients suggest
that old information is sustained in the market, as compared to more recent news. This
means that there is a time lag in reflecting the recent news in the asset prices. At any rate,
the dummy variable is still negatively significant at the 1% level, building a stronger
claim for the destabilizing effect.
Under the GJR-GARCH model, the parameters are still significant at the 1% level. In
contrast to the EGARCH model, the leverage effect is now negative which suggests that
negative shocks generate more volatility than positive shocks. Moreover, the asymmetry
ratio is higher for the GJR-GARCH model due to the negative ARCH coefficient of the
EGARCH model. Volatility is still highly persistent in the Indonesian market as the sum
of the ARCH and GARCH parameter is more than 1. The coefficient of the dummy
variable implies that the spot market volatility in Indonesia has reduced by 0.74 unit after
the inception of the futures trading. Furthermore, the dummy variable is still negatively
significant at 1% level; thus, there is a strong evidence that the introduction of futures
trading has mitigated the spot market volatility in the case of Indonesia.
This effect may be attributed to the study of Lantara (2010) in which he found out that
the use of derivatives in Indonesia are more popular among larger firms than smaller
firms. Contrary to other Asian markets, Lantara (2010) noted that most users of
derivatives in Indonesia aim to hedge against financial risks rather than so speculate. As
such, this makes the Indonesian derivatives market more efficient although they are
tightly
77
regulated, considering that their derivatives market are in the infant stage relative to other
Asian markets.
TABLE 7. GARCH Model Results for Stock Exchange of Thailand Index

(SET) Economy: Thailand
MODELS ࢽ
૙� ૚ࢻ ૛ࢻ ૚ࢼ
GARCH(1,1) 0.0006 0.11730 0.77902 -0.1696

4** *** ***
4**
(0.0003 (0.0143 (0.0222 (0.0758
1) 3) 3) 5)
EGARCH(1,1) 0.00054* -0.09532 0.22536 0.88289 -0.02578

*** *** *** ***
(0.00030)
(0.0110 (0.0233 (0.0114 (0.0099
0) 8) 1) 9)
GJR-GARCH(1,1) 0.00041 0.18559 -0.13379 0.75774 -0.26257

(0.00030) *** *** *** ***
(0.0256 (0.0228 (0.0248 (0.0714

1) 6) 3) 0)

The GARCH model results for Thailand’s market index is presented in Table 7
above. The ARCH and GARCH parameters are 0.12 and 0.78, respectively. Effectively,
the sum of both parameters is approximately 0.80, indicating that volatility is still
persistent, as evidenced by the significance level, but not as high as other ASEAN
markets. Relative to other ASEAN markets, recent news may have reflect faster in the
prices. The constant term is also significant at 5% level, meaning the will still be
volatility even if other factors were not present in the model. As for the dummy variable,
it is negatively significant at 5% level, implying that futures trading has destabilizing
effect in the spot market volatility.
Similar to other ASEAN markets, the EGARCH model shows a strong leverage effect,
wherein positive shocks are more destabilizing that negative shocks. The effect is
stronger, with a coefficient of 0.225 than the symmetric effect of -0.095. The persistence
coefficient is much higher than the GARCH model as it captures the volatility asymmetry.
The dummy variable remains to be negatively significant but now at 1% level.
The ߙଵ, ߙଶ and ߚଵ are 0.19, -0.13 and 0.76, respectively. All parameters are significant
at the 1% level. Along with GARCH model, the persistence in volatility is not as high as
the other ASEAN markets. The leverage effect with coefficient of -0.13 shows
78
that negative news destabilizes the market, a similar effect as other markets for the GJR
GARCH model. Finally, the dummy variable is negatively significant with a coefficient
of -0.26 which means that the spot market volatility declined by 0.26 unit post
establishment of the index futures in Thailand. Therefore, there is a strong evidence that
futures listing has reduced the volatility for the Stock Exchange of Thailand. Identical to
the Indonesian market, the mitigating effect may be attributable to institutional investors
being heavy users of derivative products and that their main objective is to hedge
financial risks, provided that they are still considered as developing market (Chetchatree,
2011).
Based on the results for the four Southeast Asian markets, namely Singapore, Malaysia,
Indonesia and Thailand, the first two showed that there is a destabilizing effect; however,
the last two shows that there is stabilizing effect. Furthermore, it should be noted that
both Indonesia and Thailand are the most recent ones (in 2010 and 2004, respectively) in
the ASEAN region who introduced the futures exchange. Thus, the varying effect may
have something to do with the timing of the launch, market performance, as well as
market development; simply put, each market clearly has its own unique characteristics,
level of sophistication, and regulations that sets them apart from the others (Dong &
Zhang, 2010).
TABLE 8. GARCH Model Results for Hang Seng Index

(HSI) Economy: Hong Kong
MODELS ࢽ
૙� ૚ࢻ ૛ࢻ ૚ࢼ
GARCH(1,1) 0.00162 0.22492 0.75525 -0.53085

*** *** *** ***
(0.0002 (0.0080 (0.0062 (0.1082

4) 6) 5) 0)
EGARCH(1,1) 0.00094 -0.12374 0.31981 0.94080 -0.03012

*** *** *** *** ***
(0.0002 (0.0093 (0.0119 (0.0029 (0.0065

4) 8) 8) 3) 8)
GJR-GARCH(1,1) 0.00110 0.30641 -0.23586 0.75822 -0.58168

*** *** *** *** ***
(0.0002 (0.0135 (0.0165 (0.0077 (0.0902

6) 4) 6) 3) 0)

As for the East Asian markets, Table 8 shows the GARCH results for the Hong Kong’s
Hang Seng Index (HSI). The ARCH(1) parameter (ߙଵ) is equal to 0.22 and the
GARCH(1) parameter (ߚଵ) is equal to 0.75, with standard errors of 0.008 and 0.006,
79
respectively. Moreover, the sum of ߙଵ and ߚଵ is 0.97 which approaches unity. Therefore,
this implies that shocks to the conditional variance are highly persistent. The ARCH
parameter for Hong Kong is greater than those of the ASEAN market, which implies that
news are reflected in the prices faster. With both parameters positively significant at the
1% level, this also indicates that the unexpected negative and positive returns were due to
the same magnitude of the volatility. Its dummy variable is deemed to be negatively
significant at the 1% level with a coefficient of -0.53. Thus, this provides an evidence that
futures trading may have mitigated the spot market volatility.
As for the EGARCH(1,1) model, the ߙଵ, ߙଶ and ߚଵ are -0.12, 0.32 and 0.94,
respectively. All parameters are significant at the 1% level. The sum of ߙଵ and ߚଵ also
approaches unity similar to the GARCH model. The leverage effect, which is relatively
high, suggests that unexpected price increases are more destabilizing, similar to the
ASEAN markets. The dummy variable remains to be negatively significant with a
coefficient of -0.03, much lower than that of GARCH model.
GJR-GARCH(1,1) shows that the ARCH and GARCH parameters are also positively
significant at the 1% level, indicating the persistence of volatility in HSI as it exceeds 1
again. The leverage effect is also significant but with a negative coefficient which implies
that negative shocks have greater impact than positive shocks in contrast to the
EGARCH model (Bohl et al., 2015). Though the asymmetry ratio [ߙଵ/(ߙଵ + ߙଶሻ] for
the GJR-GARCH model is higher than the EGARCH model which means that GJR
GARCH better captures the volatility asymmetry in the returns of HSI. Additionally, the
coefficient of the dummy variable shows that the spot market volatility decreased by 0.58
unit after the index futures listing. Furthermore, the dummy variable is still negatively
significant at the 1% level, with coefficient of -0.58, quite close to that of GARCH model.
Thus, there is a strong evidence that the establishment of a futures exchange has
mitigated the spot market volatility in Hong Kong, which corroborates the findings of
Lee and Ohk (1992), Gulen and Mayhew (2001), and Yu (2001).
80
According to these previous studies, the reduction in the volatility can be attributed to
increased market depth due to futures trading as well as increased speed and quality of
information. Further, Lee and Poon (2004) mentioned that the futures exchange in Hong
Kong have a substantial share of institutional investors and that their derivatives market
is very concentrated on index futures as compared to other derivative products offered,
even before the market crash in October 1987. Another evidence of Stein (1987)
suggested that futures trading still has a stabilizing effect on spot volatility even if there
are a lot of speculators present in the market as long as they are allowed to freely engage
in the spot market. Stein (1987) further explains that speculators may foster more
perfectly informed participants in the market. However, Subrahmanyan (1991) added a
caveat as the number of informed investors must be consistent over time; otherwise,
there would be an ambiguous effect on the volatility of the spot market.
TABLE 9. GARCH Model Results for Shanghai Composite Index

(SHCOMP) Economy: Shanghai
MODELS ࢽ
૙� ૚ࢻ ૛ࢻ ૚ࢼ
GARCH(1,1) -0.0000 0.20313 0.73521*** -1.84450

3 *** ***
(0.01529)
(0.0002 (0.0126 (0.0766
9) 0) 3)
EGARCH(1,1) -0.0001 -0.04290 0.29513 0.934719 -0.12784

3 *** *** *** ***
(0.0003 (0.0084 (0.0170 (0.00720 (0.0130

0) 6) 5) ) 5)
GJR-GARCH(1,1) -0.0002 0.22263 -0.09079 0.77083*** -1.90428

2 (0.01533) *** ***
(0.01386)
(0.0003 (0.0155 (0.0809
1) 0) 2)

Table 9 above presents the GARCH results for the Shanghai financial market. The
ARCH and GARCH parameters are 0.20 and 0.74, respectively, which is close to unity
and that of Hong Kong. This indicates that volatility is persistent within the ten year
range, similar to other Asian markets. Moreover, this also shows that old information is
more sustained in affecting the price of the index, but not as high as compared to its
ASEAN counterparts, At any rate, the dummy variable is negatively significant at 1%
81
level with coefficient of -1.84, a relatively greater impact, which implies that futures
trading may have reduced the spot market volatility in Shanghai.
and ࢼ
The EGARCH(1,1) model shows that ࢻ ,૚ࢻ ૛ ૚are significant at the 1% level.
Similar to other markets, the news coefficient indicates that recent news in the market has
lesser impact on the price changes thought it must be noted that the time frame in this
particular is in the 1990s when they have underwent financial liberalization. Whereas,
the leverage effect is positively significant and thus, positive shocks create more volatility
than negative shocks. The dummy variable remains to be negatively significant at 1%
level, which means that the spot market volatility decreased after the introduction of
futures derivatives in the market of Shanghai.
GJR-GARCH(1,1) model also shows significant parameters at the 1% level. The sum of
the ARCH and GARCH parameter approaches unity. The leverage effect is negatively
significant, suggesting that losses have a greater impact on volatility than gains, which is
in contrast to finding through the EGARCH model. The asymmetry ratio is also higher
for the GJR-GARCH than the EGARCH. Furthermore, the dummy variable is still
negatively significant at 1% level with a coefficient of -1.90 which means that spot market
volatility in Shanghai decreased by as much as 1.90 units after introducing the futures
trading in the market; thus, there is a strong evidence that opening a futures exchange has
mitigated spot market volatility. Interestingly, both Hong Kong and Shanghai have
mitigated their spot market volatility after futures listing as both are operating under the
Chinese authorities.
The results are consistent with the study of Bohl et al. (2015) in which they noted that
the mitigating effect can be linked to the tightly regulated nature of the Shanghai
financial market. Surprisingly, they said that the Shanghai market is dominated by retail
investors and still had a mitigating effect on the spot market volatility as compared to
other Asian markets. Furthermore, Bohl et al. (2015) suggested that this may be due to
the fact
82

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HIDDEN IN PLAIN SIGHT: THE IMPACT OF STOCK INDEX

FUTURES TRADING ON SPOT MARKET VOLATILITY OF

In Partial Fulfillment of the

Campos, Michael Anthony S.

To the different professionals, Mr. Marc Bautista, Head of Research at Metrobank,

Keywords: GARCH Model, Index Futures, Spot Market Volatility, Derivatives

JEL Classification: G10, G14, O16

CHAPTER 1: INTRODUCTION ...................................................................................

CHAPTER 2: REVIEW OF RELATED LITERATURE .......................................... 23

CHAPTER 3: FRAMEWORKS ...................................................................................

CHAPTER 4: RESEARCH METHODOLOGY .........................................................

CHAPTER 5: PRESENTATION AND ANALYSIS OF RESULTS ........................ 69

CHAPTER 6: CONCLUSION AND RECOMMENDATIONS ............................. 108

BIBLIOGRAPHY ....................................................................................................... 113

APPENDICES ............................................................................................................. 121

1.1. Background of the Research Problem

1.3. Objectives of the Study

1. To determine the impact of the establishment of a futures exchange and futures

3. To provide possible implications of the effects of the establishment of futures

1.4. Statement of Hypotheses

A. Relationship between the presence of a futures exchange and the volatility

1.5. Significance of the Study

Futures trading, in theory, augments capital surge by mitigating risk and

1. 5. 1. For Financial Institutions

While financial institutions may engage in proprietary trading, or “prop trading”,

1. 5. 2. For Institutional and Retail Investors

Institutional investors, which include corporations and financial institutions, may

The introduction of derivatives products and a formal exchange indicates the

2. 1. The Derivatives Market in the ASEAN Region

There are three stages of formal derivative exchanges in Asia according to

Alan, Karakozoglu, and Korkmaz (2015), analyzed the performance, focusing on

2. 2. ASEAN Stock Market Cointegration

Using asymmetric exponential GARCH model, or Generalized Autoregressive

Sakthivel and Kamaiah (2011) attempted to evaluate the effects of derivatives

2. 4. Derivatives Inducing Spot Market Volatility

In an attempt to receive above-average risk-adjusted returns, investors resort to

2. 5. Derivatives Showing Unchanged and Mixed Effects on Spot Volatility

Bessembinder and Seguin (1992) explored the implications of derivatives trading

As posited by the efficient market hypothesis, prices adjust according to the

As numerous studies attempt to determine the effect of introducing a derivatives

In order to determine whether derivatives trading reduced volatility in the Spanish

2. 6. Synthesis and Research Gap

Although the effects of formalized futures markets have been thoroughly

Futures derivatives mitigating spot market volatility

Kasman & Kasman (2007)

Sakthivel & Kamaiah (2011)

Matavonic & Wagner (2012)

Kang & Yoon (2015)

Gulen & Mayhew (2001)

Pilar & Rafael (2002)

Karim & Gee (2006)

Janor & Ali (2007)

3. 1. 1. Efficient Market Hypothesis

Semistrong-form EMH. The semistrong-form EMH posits that current stock

includes nonmarket information including but not limited to dividend-yield, price-to

3. 1. 2. Stabilization and Destabilization Hypothesis

The concept of volatility in stock market, as used in the empirical literature, is a

The important role of traders in stabilizing market prices is identified by buying

3. 1. 3. Theories on Futures Trading

In support to the previous framework, Subrahmanyan (1991) created a model for

3. 1. 4. Arbitrage Pricing Theory

According to Hubana (2013), cointegration is the basis of the statistical arbitrage

FIGURE 1. Schematic Diagram.

Note: * Significant at 1% level; Significant at 5% level; * Significant at 10% level.

Note: * Significant at 1% level; Significant at 5% level; * Significant at 10% level.

Note: * Significant at 1% level; Significant at 5% level; * Significant at 10% level.

Note: * Significant at 1% level; Significant at 5% level; * Significant at 10% level.