Impact of Derivatives on Stock Market

Abstract

Derivatives, such as futures or options, are financial contracts which derive their value from a spot price, which is called the “underlying”. Derivative products like index futures, stock futures, index options and stock options have become important instruments of price discovery, portfolio diversification and risk hedging in stock markets all over the world in recent times. In the last decade, many emerging and transition economies have started introducing derivative contracts. Ever since index futures were introduced by the National Stock Exchange (NSE) in June 2000, there has been a lot of controversy regarding their usage.

Derivatives are known to be a double edged sword, you can use it to kill enemies, kill yourself or for self-defense. Introduction of derivative products, however, has not always been perceived in a positive light all over the world. It is, in fact, perceived as a market for speculators and concerns that it may have adverse impact on the volatility of the spot market. Indian Government had earlier banned futures trading in commodities on the belief that they were over speculated and caused an inflationary situation. Now trading has been resumed on four banned commodities, after the inflation rate has moderated. There is also a hope that government may soon lift the trading ban on food grains. This offers great relief for importers and exporters to hedge their positions.

Earlier, an expert committee headed by Abhijit Sen was constituted to study the impact of futures trading on agricultural commodity prices. Wheat, urad, tur and rice were among the products that were considered in the report. This paper tries to study whether the Indian stock markets show some significant change in the volatility after the introduction of derivatives trading. This paper also tries to examine whether decline or rise in volatility can be attributed to introduction of derivatives alone or due to some other macroeconomic reasons.

Keywords: derivatives, volatility, impact, spot prices, derivatives and spot market, GARCH

JEL Classification: C25, C22, G12, N25, G15