Modeling the effect of Nasdaq and index futures introduction on the volatility of NSE nifty using garch methodology

Abstract

Stock market volatility has been a topic of immense importance as well as of interest in recent years. The stock market volatility is influenced by various factors, which could range from macroeconomic variables such as inflation, gross domestic product (GDP), fiscal policy, exchange rates, etc., to industry-specific information, firm-specific information, global market movements, etc. The price fluctuations of the constituent shares of a spot market largely rest on their ability to digest relevant information pertaining to the market in any form. Besides the macro and micro-economic factors, the worldwide shift in volatility of the stock market due to recent innovations in the capital markets is also a subject of scrutiny in the recent period. The thesis critically examines two important structural changes that influenced Indian Stock Market volatility in the recent period. First, the thesis critically examines the ongoing debate whether the introduction of derivatives segment destabilizes the spot market or not. The study makes a clean attempt in examining the potential shift in volatility of the spot market due to Index Futures introduction. Second, because of the implicit changes that have occurred in the Indian capital market trading floor, as a consequence of the ongoing series of liberalization measures since 1992, the domestic market has come to be largely determined by the undercurrent of the global markets in general and the NASDAQ in particular. The co-movement of the Indian stock market with the NASDAQ has evinced considerable interest and it is important to examine how the volatility transmits from the US market to Indian market. For each study, advanced techniques in time-series econometrics are employed for analyzing these issues of empirical finance in the Indian context. The first study addresses whether, and to what extent, the introduction of Index Futures contracts trading have affected the volatility structure of the underlying NSE Nifty Index. Using an informal CUSUM plot and a formal Bayesian analysis, it is first confirmed that there is indeed a shift in volatility around the time of Index Futures introduction. Then the classical F-Test (Variance-Ratio test) indicates that the spot volatility has changed since the inception of Index Futures trading. Next, the GARCH family of techniques is employed to capture the time-varying nature of volatility and volatility clustering phenomena present in the data. The results obtained from the ARMA-GARCH model indicate that while the introduction of futures trading has made no change on the underlying mean level of the returns, it has significantly altered the structure of spot market volatility. Specifically, it is found that new information is assimilated into prices more rapidly than before since the onset of futures trading, and there is a decline in the persistence of volatility. These results for NSE Nifty are obtained after accounting for world market movements, asymmetric effects and sub-period analysis, and contrasting the same with a control index, namely, NIFTY Junior. Thus, it is concluded that such a change in the volatility structure appears to be the result of introduction of futures trading, which expands the routes over which information can be conveyed to the market. The second study empirically investigates the short-run dynamic linkages between NSE Nifty in India and NASDAQ Composite in US during the recent 1999–2001 period using intra-daily data, which determine the daytime and overnight returns. A comprehensive analysis has been carried out from correlation to Granger causality in both linear and nonlinear way. Next, GARCH models have been applied to examine the co-movement and volatility transmission between the US and Indian stock markets. The results are broadly the same even if one uses S&P 500 instead of NASDAQ Composite to represent the US stock market. In particular, the study applies Two-Stage GARCH Model, Multivariate GARCH model and a simple Univariate GARCH model to examine the linkages between the markets, and it is found that the simple Univariate GARCH model performs at least as well, if not better than its more complex counterparts, in terms of in-sample and out-of-sample forecast evaluations. It is found that on an average the effect of NASDAQ daytime return volatility shocks on Nifty overnight return volatility is 9.5% and that of Nifty daytime return is a mere 0.5%, implying that the conditional volatility of Nifty overnight returns is to some extent imported from US.