Ebook Single-Stock Futures: Evidence from the Indian Securities Market
Single-stock futures (SSFs) represent a significant development in stock related derivatives. It is an academic as well as practical conundrum as to why SSFs, as a derivative product, have not gained widespread acceptance in most markets, particularly in developed markets. We analyze the Indian securities market for evidence about the role of SSFs and their effectiveness in terms of price information and transmission.
SSFs traded on the National Stock Exchange of India (NSE) have grown substantially since their inception in 2001. Why have other markets struggled to generate interest among investors for SSFs? A stock futures contract provides a way to take advantage of arbitrage, speculative, and hedging opportunities, reducing trading pressures on the underlying markets. Without futures contracts on individual stocks, arbitrageurs and investors must trade in the underlying assets, or trade options and index products.
The US typically has the most vibrant markets for stocks and derivative products. Passage of the Commodity Futures and Modernization Act of 2000 made SSFs legal in the US by repealing the Shad-Johnson Accord some 20 years after its inception. On November 8, 2002, two exchanges, OneChicago and the Nasdaq Liffe Market (NQLX), started SSF trading. Single-stock futures offer a cheap and flexible way to gain equity market exposure for a wide range of purposes, such as hedging, speculation, and financial engineering. Yet the development of SSFs has been unimpressive in the US, the largest and the most sophisticated securities market in the world. Nor has SSF trading fared well in exchanges of other countries that have launched SSFs.
Research so far has concentrated on developed and matured markets for an understanding of the reception of SSFs. We look at the Indian market, where we see remarkable progress in SSF trading. Since their launch in November 2001, SSFs have showed incredible progress, making the NSE, the most vibrant SSF market in the world. The Futures Industry Association (July/August 2006) reports the NSE as the 13th-largest derivatives exchange by volume, and the NSE has the largest trading volume in SSFs worldwide. Thus, it is the largest global exchange for single-stock futures. In 2004, the NSE traded more than 25 million SSF contracts. Euronext.liffe, the second-largest exchange for this product, was far behind, at 7.5 million contracts.
Our research investigates the success of SSFs in the Indian market and analyzes price discovery mechanics. We examine the most comprehensive sample of stocks and stock futures available over 12 months (252 trading days). We examine SSF evolution and benefits, their failures and successes. We also examine the roles of regulatory forces and institutional trades in price discovery of SSFs and their underlying stocks.
Our research makes several contributions to the literature on single-stock futures by relating their benefit and success through retail participation. We evaluate the contribution of timely regulatory initiatives in broadening the SSF market. We attempt to corroborate how the success of SSFs may alter the dynamics of price leadership and information share.
There is some evidence that SSF trading improves market efficiency. Ang and Cheng (2005) find that SSFs have a stabilizing influence on a market. SSFs with lower trading costs and higher leverage provide better relief for arbitrageurs than for speculators. In a study of stock futures trading in Australia, Lee and Tong (1998)conclude that SSF trading offers many benefits associated with derivatives trading without increasing volatility or instability in the market. An increase in volume in the underlying stock markets has made stock brokers less wary of losing market share and profits to the SSF market. The SSF market is both more cost-effective and more informationally efficient than the stock market in terms of transaction costs and price discovery.
Our findings for the Indian stock market suggest that the trades in the stock market perform better in terms of price discovery and information share than do trades in the SSF market. This result is contrary to previous findings that derivatives account for more price discovery and price leadership. However, quotes on SSF market lead quotes from stock market in contributing to price discovery. As the SSF market attracts sophisticated investors, both individual and institutional, the SSF market leads in adding information about a stock’s intrinsic value from quote postings, while the stock market disseminates that value to all market participants through trade transactions. As such, each market is mutually dependent in price innovation and formation and neither market free-rides on the other.
More than 93% of the contracts traded in the SSF market are from single contract trades. This indicates the dominant participation of retail investors in the SSF market. As retail investors are not well-informed investors, the price discovery function takes place in the underlying stock market despite higher trading volume in SSFs, which is 1.6 times that of stock trading. Examining the information content of institutional trades on the London Stock Exchange, Bozcuk and Lasfer (2005) find that the type of investors, the combination of the size of the trade, and investors’ resulting level of ownership are the major determinants of price impact. Institutional and individual investors observe news or price movements in different ways, process such information differently, and thus trade accordingly. Because institutional investors are more sophisticated and have greater resources, they are in a better position to influence price discovery for a security. A price pressure hypothesis implies that institutional trades influence price formation in a market more than trades by individuals. However, in the SSF market in India, there are fewer institutional investor trades than the retail investor trades.
One plausible reason for the success of SSFs on the NSE could be the absence of an efficient or active stock lending mechanism in the equity market. A competing hypothesis is that of the three markets – the equity market, the stock lending market, and the SSF market, whichever two first appear would act as a hidden market for the third. In the case of India, the equity and SSF markets surfaced first, and so the SSF market may be seen as a supplement for the stock lending market. In the case of the US, the equity and the stock lending markets developed first, so together they act as a complement for the SSF market. This hypothesis further theorizes that even if the third market is introduced later on, it will not necessarily expand or develop, as the other two markets would continue to offer a hidden market. That may be the reason for lackluster response to SSFs in the US or other developed markets that have vibrant stock lending markets.
Our general results are inconsistent with the view that derivatives markets (in our case, SSFs) accounts for more of an information share and are responsible for more price discovery in multi-market trading in the same underlying security. Overall, we believe that direct retail participation is a necessary ingredient for the development of a healthy SSF market. Our results indicate that institutional trading (or the lack of trading) has an effect on price discovery, as the participation of institutional investors makes prices more informative. But for a successful SSF market, it is essential that stock and SSF markets are mutually dependent in price innovation and formation.
The remainder of this study is organized as follows: in section 2, we discuss the development of SSF market, section 3 describes the data construction and methodology, section 4 contains the empirical results, and the final section concludes the paper.
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