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The Impact of the Introduction of Index Options on Volatility and Liquidity on the Underlying Stocks

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The Impact of the Introduction of Index Options on Volatility and Liquidity on the Underlying Stocks The impact of the Introduction of index options on volatility and liquidity on the underlying stocks : Empirical evidence from the Asian stock markets. Authors: Hasan, Md Kamrul Chowdhury, Shabyashachi Supervisor: Lions, Catherine Student Umeå School of Business Spring semester 2011 Master thesis, two-year, 30 hp ABSTRACT The impact of the introduction of derivatives on the underlying stock is a debatable topic among the researchers. The issue is quite controversial as contradictory results have been obtained by researchers in various stock markets. The purpose of this study is to examine the volatility and the liquidity effect on the underlying stock after the introduction of index options. We have investigated volatility and liquidity effect by collecting sample data from the stock markets of India, Korea, Taiwan, Hong Kong, Japan, Thailand, Malaysia and Singapore, only markets which are offering index options in Asia. Applying the generalized autoregressive conditional heteroscedasticity (GARCH) model, we have examined the conditional volatility of intraday (high frequency) returns for each stock market, before and after the introduction of index options. We have also examined the liquidity effect through t-test and Wilcoxon Signed Rank Test. We used t- test to determine the mean differences between the trading volume of pre-index and post-index options periods. By comparing the estimated parameters and the coefficient of conditional volatility in pre and post period of index options introductions, we have examined that the derivatives trading dramatically increases the persistence of the conditional volatility for all the selected stock markets. We also observed mixed evidence in context to liquidity effect. In the stock exchanges of Hong Kong, Japan, Korea, Taiwan and Thailand, we found that the respective markets become more liquid in the post index options periods in contrast to pre index options period. In these markets trading volume increased significantly after the introduction of index options. On the other hand, India, Malaysia and Singapore stock markets show no liquidity effect in the post-index option period. Finally, the empirical results of our study conclude that the introduction of index options on the selected Asian stock markets have increased in stock return volatility and liquidity on the underlying stocks. Key words: Derivatives; Volatility; Liquidity; Index Options; Intraday return; Trading volume; Conditional volatility; Stock return volatility; Impacts; Underlying stocks ii ACKNOWLEDGEMENTS First of all, we would like to appreciate our supervisor Catherine Lions for her valuable criticism, guidance, useful advice for how to develop this study on the introduction of index options and its impact on the underlying stocks. Furthermore, we would like to thank people who helped us in different stages of writing this thesis. We would like to give special thanks to Magnus Olsson and Annika Bindler from Umeå University. Last but not least, we are truly grateful to our beloved family members and friends who have always inspired us to work on this thesis throughout the entire period. Umeå, May 2011. Md. Kamrul Hasan & Shabyashachi Chowdhury iii TABLE OF CONTENTS 1 INTRODUCTION .............................................................................................................. 1 1.1 PROBLEM BACKGROUND: .................................................................................................. 1 1.2 RESEARCH QUESTION:....................................................................................................... 3 1.3 PURPOSE OF THE STUDY: ................................................................................................... 3 1.4 DELIMITATIONS:.............................................................................................................. 4 1.5 DISPOSITION: ................................................................................................................. 4 2 THEORETICAL METHODOLOGY ....................................................................................... 5 2.1 CHOICE OF SUBJECT: ......................................................................................................... 5 2.2 PERSPECTIVE: ................................................................................................................. 5 2.3 PRECONCEPTIONS: ........................................................................................................... 6 2.4 RESEARCH PHILOSOPHY: .................................................................................................... 6 2.4.1 ONTOLOGICAL FOUNDATIONS: ................................................................................................. 7 2.4.2 EPISTEMOLOGICAL FOUNDATIONS: ........................................................................................... 7 2.5 RELATIONSHIP BETWEEN THEORY AND EMPIRICAL OBSERVATIONS: .............................................. 8 2.6 NATURE OF STUDY: .......................................................................................................... 9 2.7 RESEARCH DESIGN: ........................................................................................................ 10 2.8 RESEARCH METHOD: ...................................................................................................... 10 2.9 LITERATURE SEARCH AND CRITIQUE: ................................................................................... 11 2.9.1 SELECTION OF SOURCES: ....................................................................................................... 11 2.9.2 CRITICISM TO SECONDARY LITERATURE SEARCH: ........................................................................ 11 3 LITERATURE REVIEW .................................................................................................... 13 3.1 STOCKS AND STOCK EXCHANGES: ....................................................................................... 13 3.2 STOCK MARKET INDEX: ................................................................................................... 13 3.2.1 TYPES OF STOCK INDEX: ........................................................................................................ 14 3.2.2 IMPORTANCE AND USES OF STOCK INDICES: .............................................................................. 15 3.2.3 PROBLEMS WITH STOCK MARKET INDICES: ................................................................................ 16 3.3 PERFECT MARKET AND EFFICIENT MARKET: ........................................................................... 17 3.4 VOLATILITY: ................................................................................................................. 18 3.4.1 VOLATILITY IN STOCK MARKET: ............................................................................................... 18 3.4.2 MEASURING DIFFERENT KINDS OF VOLATILITIES: ........................................................................ 18 3.4.3 RISK AND VOLATILITY: ........................................................................................................... 20 3.4.4 DERIVATIVES AND UNDERLYING MARKET VOLATILITY: ................................................................. 21 3.5 LIQUIDITY: ................................................................................................................... 22 3.6 DERIVATIVES: ............................................................................................................... 24 3.6.1 HISTORY AND GROWTH OF DERIVATIVES: ................................................................................. 24 3.6.2 FUTURES, FORWARD AND OPTIONS: ........................................................................................ 26 3.6.3 HOW OPTIONS CONTRACT WORKS: ......................................................................................... 27 3.6.4 INDEX OPTIONS: .................................................................................................................. 28 3.6.5 CHARACTERISTICS AND APPLICATIONS OF DERIVATIVE MARKETS: .................................................. 30 3.6.6 IMPERFECTION IN DERIVATIVE MARKETS: ................................................................................. 31 3.6.7 DERIVATIVES AND MARKET EFFICIENCY: ................................................................................... 32 iv 3.7 SUMMARY OF THE LITERATURE REVIEW: .............................................................................. 32 3.8 DEVELOPED THEORETICAL FRAMEWORK MODEL: ................................................................... 33 4 PRACTICAL METHODOLOGY ......................................................................................... 34 4.1 SAMPLE DATA: ............................................................................................................. 34 4.2 TIME HORIZON: ............................................................................................................ 34 4.3 DATA COLLECTION METHOD: ............................................................................................ 35 4.4 MARKET INFORMATION: ................................................................................................. 35 4.4.1 HONG KONG ....................................................................................................................... 35 4.4.2 INDIA ................................................................................................................................
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