Study of the impact of derivatives on the Indian stock market

Abstract

The impact of the introduction of derivatives on the Indian spot market is the primary focus of this study. First the volatility of the spot market before and after the introduction of derivatives has been analyzed, and the conclusion that the spot market volatility reduced after the introduction of derivatives was drawn. However, this reduction in volatility could also have been due to structural changes in the stock market. So the impact of introduction of T+3 and then T+2 settlement cycles was studied. It was found that these changes contributed to increase the market volatility. However, the reduction in volatility due to derivatives was greater, resulting in a net reduction in market volatility. Reasons for reduction in market volatility due to the introduction of derivatives have also been qualitatively and quantitatively analyzed. Derivatives resulted in greater liquidity and lower impact costs in the Indian spot market. This led to more stocks being actively traded and a reduction in the dependence of the market on a few stocks. The high protection offered by the derivative market, compared to the earlier carry forward system resulted in higher participation in the market. The low brokerage and margin requirements in the derivative markets, compared to the spot markets, resulted in the speculators shifting from the spot to the derivative markets. Next we investigated the impact of spot market volatility on the trading volume in the derivative market. Although there was no relation between monthly trading volumes and monthly volatility, the intra-day volatility of the spot market results in increased volumes in the derivative market. As the two markets are inter-linked, higher volumes in the derivative market in turn can result in greater volatility in the spot market. Moreover, the low brokerage and margin requirements are providing a much higher leverage in the derivative market – thus encouraging speculation. The structure of the F&O market is such that the traders can provide even greater leverage to a few players at the cost of CCS Project Reports. The cash settlement system too, penalizes the hedger and rewards the speculator. Thus the Indian derivative market is much better suited to speculators.