THE IMPACT OF SINGLE STOCK FUTURES ON THE SOUTH AFRICAN EQUITY MARKET by JOHANNES SCHEEPERS DE BEER submitted in fulfilment of the requirements for the degree of MASTER OF COMMERCE in the subject BUSINESS MANAGEMENT at the UNIVERSITY OF SOUTH AFRICA Supervisor: PROF J MARX NOVEMBER 2008 DECLARATION Student number: 3449-635-1 I declare that THE IMPACT OF SINGLE STOCK FUTURES ON THE SOUTH AFRICAN EQUITY MARKET is my own work and that all the sources that I have used or quoted have been indicated and acknowledged by means of complete references. ______________________ ______________________ Signature Date (JS De Beer) ACKNOWLEDGEMENTS I acknowledge the contribution of the following people: Professor Johan Marx, my supervisor, for his guidance and support that enabled me to complete this study. Ms Karabelo Pooe and the late Ms Faeza Sallie at the JSE Limted (Safex), providing me with the data on single stock futures. Ms Cecilia du Plessis for her assistance with a literature search on the various library databases. Ms Sandra Mills for the editing of my dissertation. SUMMARY The introduction of single stock futures to a market presents the opportunity to assess an individual company’s response to futures trading directly, in contrast to the market-wide impact obtained from index futures studies. Thirty-eight South African companies were evaluated in terms of a possible price, volume, and volatility effect due to the initial trading of their respective single stock futures contracts. An event study revealed that SSF trading had little impact on the underlying share prices. A normalised volume comparison pre to post SSF trading showed a general increase in spot market trading volumes. The volatility effect was the main focus of this study with a GARCH(1,1) model establishing a volatility structure (pattern of behaviour) per company. Results showed a reduction in the level and changes in the structure of spot market volatility. In addition, a dummy variable regression could find no evidence of an altered company-market relationship (systematic risk) post futures. Key terms: Equity shares; event study; futures trading; GARCH model; price effect; single stock futures; spot market; volatility effect; volatility level; volatility structure; volume effect OPSOMMING Die instel van enkel-aandeeltermynkontrakte in ‘n mark bied die geleentheid om ‘n individuele maatskappy se reaksie op termynverhandeling regstreeks te beoordeel, in teenstelling met die mark-wye impak wat deur indeks-termynkontrakstudies verkry word. Agt en dertig Suid- Afrikaanse maatskappye is beoordeel in terme van ‘n moontlike prys-, volume- en volatiliteiteffek op grond van die aanvanklike verhandeling van hul onderskeie enkel-aandeeltermynkontrakte. ‘n Gebeurtenisstudie het getoon dat EAT-verhandeling ‘n geringe impak op die onderliggende aandeelpryse gehad het. ‘n Genormaliseerde volumevergelyking voor en ná EAT-verhandeling het ‘n algemene toename in kontantmarkverhandelingsvolumes getoon. Die volatiliteiteffek was die hooffokus van hierdie studie. ‘n GARCH(1,1)-model is toegepas, en dit het ‘n volatiliteitstruktuur (gedragspatroon) per maatskappy daargestel. Resultate toon ‘n afname in die vlak van en veranderinge in die struktuur van kontantmarkvolatiliteit. Daarbenewens het ‘n fopveranderlikeregressie geen bewys van ‘n veranderde maatskappy-tot-mark-verhouding (sistematiese risiko) ná termynverhandeling gevind nie. Sleutelterme: Ekwiteitsaandele; enkel-aandeeltermynkontrakte; GARCH-model; gebeurtenisstudie; kontantmark; pryseffek; termynverhandeling; volatiliteiteffek; volatiliteitstruktuur; volatiliteitvlak; volume-effek TABLE OF CONTENTS CHAPTER 1 INTRODUCTION 1.1 Background --------------------------------------------------------------------------------------------- 1 1.1.1 International research -------------------------------------------------------------------------- 2 1.1.1.1 Australia ------------------------------------------------------------------------------- 2 1.1.1.2 India ----------------------------------------------------------------------------------- 4 1.1.1.3 United States of America ------------------------------------------------------------ 4 1.1.1.4 United Kingdom ---------------------------------------------------------------------- 5 1.1.2 Research in South Africa ----------------------------------------------------------------------- 6 1.2 Problem statement ------------------------------------------------------------------------------------- 8 1.3 Purpose of the research ------------------------------------------------------------------------------- 8 1.4 Research methodology -------------------------------------------------------------------------------- 8 1.4.1 Price effect -------------------------------------------------------------------------------------- 8 1.4.2 Volume effect ----------------------------------------------------------------------------------- 9 1.4.3 Volatility effect --------------------------------------------------------------------------------- 9 1.5 Presentation structure of the study ------------------------------------------------------------------- 9 CHAPTER 2 OVERVIEW OF SINGLE STOCK FUTURES AND RELATED CONCEPTS 2.1 Introduction ------------------------------------------------------------------------------------------- 11 2.2 Trading environment --------------------------------------------------------------------------------- 11 2.3 Derivatives market ----------------------------------------------------------------------------------- 12 2.4 Terminology and concepts -------------------------------------------------------------------------- 15 2.4.1 Arbitrage, hedging and speculation ------------------------------------------------------- 15 2.4.2 Short selling ----------------------------------------------------------------------------------- 16 2.4.3 Open interest ---------------------------------------------------------------------------------- 17 2.4.4 Volatility --------------------------------------------------------------------------------------- 17 2.4.5 Leverage --------------------------------------------------------------------------------------- 17 2.4.6 Mark to market ------------------------------------------------------------------------------- 18 2.5 Market efficiency, completeness, stability and interaction -------------------------------------- 18 i Table of Contents 2.6 Single stock futures ---------------------------------------------------------------------------------- 21 2.6.1 Growth ----------------------------------------------------------------------------------------- 22 2.6.1.1 Transactions (trades) --------------------------------------------------------------- 23 2.6.1.2 Contracts (volume) ----------------------------------------------------------------- 24 2.6.1.3 Value -------------------------------------------------------------------------------- 25 2.6.1.4 Open interest ----------------------------------------------------------------------- 26 2.6.2 Benefits from trading SSF contracts -------------------------------------------------------- 27 2.6.3 Contract specifications ----------------------------------------------------------------------- 28 2.6.4 Pricing ------------------------------------------------------------------------------------------ 29 2.6.5 Mechanics of trading ------------------------------------------------------------------------- 30 2.6.6 Options on SSF contracts --------------------------------------------------------------------- 31 2.7 Other/related single equity derivatives ---------------------------------------------------------- 32 2.7.1 Equity warrants ------------------------------------------------------------------------------- 32 2.7.1.1 Protected share investments (PSI) ------------------------------------------------ 34 2.7.1.2 Share instalments (SI) -------------------------------------------------------------- 35 2.7.1.3 Barrier warrants -------------------------------------------------------------------- 36 2.7.2 Can-do derivatives --------------------------------------------------------------------------- 37 2.7.3 Contracts for difference (CFD) -------------------------------------------------------------- 37 2.8 Summary ---------------------------------------------------------------------------------------------- 38 CHAPTER 3 RESEARCH METHODOLOGIES AND STATISTICAL TECHNIQUES 3.1 Introduction ------------------------------------------------------------------------------------------- 40 3.2 Price effect ------------------------------------------------------------------------------------------- 41 3.2.1 Event study methodology -------------------------------------------------------------------- 42 3.2.2 Normal return models ------------------------------------------------------------------------ 44 3.2.3 Market model --------------------------------------------------------------------------------- 45 3.2.4 Measuring and analysing abnormal returns ----------------------------------------------- 46 3.2.5 Estimation of the market model ------------------------------------------------------------- 47 3.2.5.1 Statistical properties of abnormal returns (AR) --------------------------------- 48 3.2.5.2 Aggregation of abnormal returns (CAR) ---------------------------------------- 49 3.2.5.3 Tests for significance --------------------------------------------------------------- 50 3.2.5.4 Problems with specifications ------------------------------------------------------ 51 3.2.6 Abnormal returns modelled as regression coefficients -----------------------------------