Expiration Day Impact On The Indian Spot Market Volatility

ABSTRACT

This paper examines the impact of expiration of derivatives on the spot market volatility. The study uses daily data of National Stock Exchange of India from June 12, 2000 to December 31, 2015. It is noticed that in Indian stock exchanges, the expiration effect is not restricted to expiration days; it impacts the entire expiration week. To examine this attribute, the expiration day and the expiration weeks are taken into consideration to find out the volatility in the underlying spot market. The results of the GARCH, TGARCH, EGARCH indicate that for the entire period undertaken for study, the derivatives expiration days/weeks are considerable factors in enhancing the volatility of the spot market. It is observed that the expiration day impact is primarily owing to increased volumes in near-month contracts and following the cash based settlement system. The observations may be applied by the investors to strategize their investments in the derivatives and the spot market respectively and also by the policy makers to consider upon a more appropriate settlement system.

JEL classification: G12, G14.

INTRODUCTION

Spot market volatility dynamics is recognized to be influenced by the expiration day effect on the expiration of derivative contracts. It is identified to be triggered by trading strategies of arbitrageurs and speculators, and is documented by the settlement procedure followed in a specific market. Increased volatility reduces the effectiveness of a hedge made by arbitrageurs as they unwind their position in proportion to the volume traded during the relevant period, which cannot be estimated specifically in advance. If numerous arbitrageurs liquidate around the same time and in the similar direction, price effects are probable. A further potential explanation for expiration day price effects is the conscious attempts to manipulate prices wherein a speculator with a naked position in an expiring contract might have a considerable financial interest in the contract’s settlement price and thereby willing to place small cash market trades at non-equilibrium prices to influence the index in a constructive direction. It is observed that around and during expiration days during the settlement of derivative contracts, there is a significant increase in volume and volatility across the exchanges.

This paper examines the expiration effects on the market index as opposed to prices of individual stocks thereby extenuating problems that may occur due to information that affects prices of individual stocks considerably more than a broader market index. The market indices are likely to be affected less by liquidity effects than the prices of individual stocks. Furthermore, the turnover in the index derivatives markets is significantly greater than that in the market for derivatives products related with individual stocks. Hence, expiration day effects are likely to be much more prominent for market indices than for individual stocks. In this study, the GARCH model and the asymmetric GARCH model like TGARCH and EGARCH are applied to capture the expiration day/week effects. The present study examines the expiration day effects and the expiration week effects on the spot market volatility during the post-derivatives period taking into account the longest time period of study in the Indian context.

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