The effect of derivatives trading on the underlying spot volatility:

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The effect of derivatives trading on the underlying spot volatility:

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Title: The effect of derivatives trading on the underlying spot volatility:
Evidence from the Swedish OMXS30 index and its component stocks
Author: Jacobsen, Johnni Ulrich; Lind, Eske
Abstract: This thesis examines if derivatives trading activities affect the volatility of the underlying asset. The investigation is conducted on derivatives on the Swedish major index, OMXS30, and on selected components stocks. Based on our theoretical investigation we find that hedgers and speculators use derivatives differently, and that their trading activity can be approximated by trading volume and open interest. Through a number of information hypotheses we find that there is a relation between trading activity, information and volatility. From investigation of previous research and stylized facts of the data, we settle on an ARMA-GJR-GARCH model for our empirical testing. Based on this model we conduct several tests to answer if derivatives trading activity affect the volatility of the underlying asset. The tests are conducted on index- and on asset level. On index level we find that derivatives trading do affect the underlying volatility of the OMXS30. This was documented both over the whole analysed period and in the subperiods. Also, we find significant leverage effect, which corresponds to the results in other research. We also find that speculators’ trading activities tend to increase the volatility, while hedgers tend to stabilise the market. Especially shocks from speculators are found large and positive, while the overall effect from trading is negative due to a stabilizing effect from hedgers’ trading. Our findings support the Mixture of Distribution Hypothesis and contradict the Dispersion of Believes Hypothesis, and we can thus conclude that some agents affect the underlying volatility more than others. Furthermore, we do not find support for the hypothesis, that derivatives trading activity changes in accordance with the market conditions. On asset level we find a large and positive relation between unexpected shocks from speculators and the underlying volatility, for the whole period. We therefore conclude that derivatives trading do affect the underlying volatility and speculators are the market participants that affect volatility the most.
URI: http://hdl.handle.net/10417/1539
Date: 2011-01-13
Pages: 158 s.
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