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Running head: DISSERTATION PROPOSAL,
Dissertation Proposal:
Do futures and options trading increase stock market volatility?
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Abstract
This dissertation aims to study the implications on the volatility of the stock market after
introducing index futures and options trading. Several studies conducted on how futures and
options affect the volatility of spot markets have shown that introducing the derivative products
rarely stabilizes the underlying market, though derivative contracts can help
improving
liquidity while reducing asymmetries in the market (Butterworth, 2000). Stock markets in
developed countries operate in different economic, political, social and technological
environments compared to the emerging and developing markets. This paper will focus on the
implications of introducing derivative trading on the volatility of cash markets by employing
data from the stock index futures and options contracts traded on the FTSE 100 index in the UK.
The expected results are that introducing index futures on the spot market will affect its volatility
(Illueca & Lafuente, 2003), This research will be especially important to regulators and stock
exchange officials who will look towards designing the contract specifications as a trading
mechanism for derivative contracts.
Introduction
Derivative products such as futures and options trading are important instruments when
discussing price discovery and risk hedging, Derivative markets work concerning spot markets
since they provide several functions such as risk management and price discovery (Chance &
Brooks, 2015). Institutional investors and mutual fund managers use derivatives in risk
management to hedge any risk that arises in the spot market, which means their trading rarely
affects the uncertainty in the stock market. An increase in the volatility of a spot market can
affect the economy by raising inflation and exchange risk. Introducing derivatives such as futuresDISSERTATION PROPOSAL 3
and options trading can reduce the costs of transacting large volumes relative to the cash market
(Chance & Brooks, 2015).
Price discovery and risk transfer are significant contributors to future markets when
looking towards organizing economic activities. This issue on how index futures affect the
volatility of spot market volatility has continued to raise public interest, arising from the
destabi
ing perception surrounding index futures based on some stock market crashes (Illueca
& Lafuente, 2003). The 1987 US market crash, as well as the 2010 US flash crash, are some of
the reasons driving people to understand the effects of introducing futures and options trading.
Volatility is thus an important area of interest for both market regulators and participants, with a
less volatile market preferred to more instability (Campbell, Lettau, Malkiel & Xu, 2001).
The first stock index future happened in 1982 when the Kansas City Board of Trade
introduced the Value Line Contract (Rahman, 2001). The aspect opened the way for numerous
other derivative contracts, getting added in the world on an annual basis, mostly in the developed
countries. However, despite the long history of introducing derivative products and future
arrangements on the stock market, controversy still exists over the impact of futures trading on
the volatility of the underlying stock market. The concern developed over whether futures and
options trading heightened after the stock market decline of 1987 in the United States
(Butterworth, 2000).
‘The derivative products were blamed for the crash of some stock markets in 1987 within
the United States. This was after developed countries started introducing commodity and
financial futures for options trading. The crashing led to fears that the introduction of futures can
increase the volatility of spot markets (Rahman, 2001). Today, most policymakers in such
economies are concerned with how these features can affect the underlying cash markets.DISSERTATION PROPOSAL 4
The concern about introducing derivative products stems from beliefs that trading of
futures can attract speculators who may then destabilize the spot prices.
Itis in this regard that this research builds its foundation, focusing on the areas that are yet.
to be exploited. The study looks to determine solutions to questions such as how derivatives
affect the liquidity of the underlying cash market, whether they destabilize the financial system
and how to address the identified risks. Getting a meaningful interpretation of volatility and how
introducing futures can affect it can help regulators in the spot market (Wagner & Matanovic,
2012). This paper looks towards understanding the literature on futures and options trading by
focusing on the developed market of the United Kingdom. It seeks to examine the impact of
introducing financial derivatives on the volatility of cash markets. The outcomes of the research
will help investors, regulators and stock market officials understand the effect of introducing
derivatives and their efficiency or instability in the underlying cash markets (Bohl, Diesteldorf &
Siklos, 2015),
Methodology
The study will be conducted to investigate the implications of futures and options trading
on underlying spot market volatility. It looks to analyze the effect of introducing future contracts
on the volatility of spot price while considering several measures of instability and the dynamic
linear regression model (Reyes, 1996). The study will examine the impact of FTSE 100 index
futures on the spot price market using the GARCH model. Data relating to the price series will
be obtained from the FTSE website among other vital sites that can provide information on the
stock market, Additionally, data on the FTSE 100 index will be collected from financial websites
with all estimations done using SAS. The FTSE 100 is an index of 100 stocks traded on the
London Stock Exchange with the highest market capitalization.DISSERTATION PROPOSAL 5
This paper will employ the methodologies used in the past research by using the GARCH
model. This model is used when modeling the volatility processes over time as opposed to the
use of estimated standard deviations in measuring volatility (Engle, 2001). The technique will
help in determining the link between the introduction of future information and its effect on the
volatility of cash markets to assess any change:
the volatility. GARCH model will also be
used to capture the tendency of a return to exhibit volatility in the spot market. In this study, the
GARCH (1, 1) model will be used since it fits the data better than other models. It is easier to
forecast the multi-period error variance in this model. The GARCH model will help in predicting
the conditional error standard deviation over time by capturing the temporary increase in the
volatility after introducing future contracts (Engle, 2001). Furthermore, a dummy variable in the
conditional volatility equation will be presented to help in estimating how entering index futures
will affect the market measure by a positive coefficient for an increase and negative coefficient
for a decrease in volatility.
Objectives
The goal of this research will be to investigate the impact of futures adoption trading on the
volatility of the spot market. The specific objectives of this study will include
1. Examining the implications of introducing future contracts and options trading on the
volatility of spot price.
2. Determining whether introducing future contracts and options trading will change the
volume of the spot market and affect its liquidity.
3. Tam examining whether introducing future contracts and options trading creates a
leverage effect on the spot market volatilityDISSERTATION PROPOSAL
Expected results
‘The research looks towards understanding any implications on the stock market volatility
after introducing futures and options trading. It will test whether there will be any structural
change in the spot market at the onset of futures trading in terms of volatility (Wagner &
Matanovic, 2012). The expected outcome of the research is that options trading increased the
volatility of stock markets after the introduction. It is also anticipated that futures and options
trading improves the quality and rate of information flow on the spot market rate. The results
will be measured based on the mean equation before and after introducing the futures and
options trading. At the same time, the research expects to show that introducing futures and
options trading does not affect the volatility of the spot market (Caglayan, 2011). The expected
result is that the nature of the GARCH process will change after entering future trading.
However, economies might expect uncertainties in the market after opening derivative contracts
in real life.DISSERTATION PROPOSAL 7
References
Bohl, M. T., Diesteldorf, J., & Siklos, P. L. (2015). The effect of index futures trading on
volatility: Three markets for Chinese stocks. China Economic Review, 34, 207-224.
Butterworth, D. (2000). The impact of futures trading on underlying stock index volatility:
The case of the FTSE Mid 250 contract. Applied Economics Letters, 7(7), 439-442.
Gaflayan, E. (2011). The impact of stock index futures on the Turkish spot market. Journal
of Emerging Market Finance, 10(1), 73-91.
Campbell, J. Y., Lettau, M., Malkiel, B. G., & Xu, Y. (2001). Have individual stocks
become more volatile? An empirical exploration of idiosyncratic risk. The Journal of
Finance, 56(1), 1-43.
Chance, D. M., & Brooks, R. (2015). Introduction to derivatives and risk management.
Cengage Learning.
Engle, R. (2001). GARCH 101: The use of ARCH/GARCH models in applied
econometrics. Journal of economic perspectives, 15(4), 157-168.
Illueca, M., & Lafuente, J. (2003). The effect of spot and futures trading on stock index
market volatility: A nonparametric approach. Journal of Futures Markets: Futures,
Options, and Other Derivative Products, 23(9), 841-858.
Rahman, S. (2001). The introduction of derivatives on the Dow Jones Industrial Average
and their impact on the volatility of component stocks. Journal of Futures Markets:
Futures, Options, and Other Derivative Products, 21(7), 633-653.
Reyes, M. G. (1996). Index futures trading and stock price volatility: Evidence from
Denmark and France. Journal of Economics and Finance, 20(3), 81.DISSERTATION PROPOSAL
Wagner, H., & Matanovic, E. (2012). Volatility Impact of Stock Index Futures Trading-A
Revised Analysis.