Stock Index Futures Trading and Volatility in International Equity Markets

We examine stock market volatility before and after the introduction of equity index futures trading in twenty-five countries, using various models that account for asynchronous data, conditional heteroskedasticity, asymmetric volatility responses, and the joint dynamics of each country’s index with the world market portfolio. We find that futures trading is related to an increase in conditional volatility in the United States and Japan, but in nearly every other country, we find either no significant effect, or a volatility-dampening effect. This result appears to be robust to model specification, and is corroborated by further analysis of the relationship between volatility, trading volume and open interest in stock futures. We also document an increase in conditional covariance between country-specific and world returns at the time of futures listing. The world’s first stock index futures contract was the Value Line contract, introduced by the Kansas City Board of Trade on February 24, 1982. Today, stock index futures and options trade in markets all over the world, with new contracts launched nearly every year. Table 1 reports launch dates for thirty nations that introduced stock index futures between 1982 and January, 1998. In addition, plans are underway for exchange-listed index futures in many other nations, including India, Indonesia, Czech Republic, Slovakia, Turkey, and others. As exchange-traded stock index futures and other derivatives become more pervasive in the world’s financial markets, it is increasingly important to understand the effect of derivatives trading on the underlying markets. The previous literature on the effects of stock index futures trading has focused primarily on developed markets, and it is unclear to what extent these results are applicable to less-developed markets. Moreover, the existing research has come to conflicting conclusions regarding the effect of futures trading on volatility. Some authors have found that volatility appears to increase with the introduction of futures, and some find no significant effect, and some find that volatility decreases.1 In this paper, we examine the time series properties of stock indexes in twenty-five countries, in order to investigate the impact of stock index futures listing and subsequent trading activity on the volatility structure of the underlying cash market. We examine this issue in two ways. First, we test for structural changes at the time of futures listing by comparing properties of the returns series before and after listing. Second, we test whether volatility in the post-listing period is related to futures market volume and open interest. The results of both tests show that futures trading is associated with increased volatility in the United States and Japan, but in virtually every one of the other twenty-three countries, this is not the case. In some countries, there is no robust, significant effect, and in many others, futures trading is associated with lower volatility. For a detailed summary of this literature, see surveys by Hodges (1992), Damodaran and Subrahmanyam (1992), Sutcliffe (1997) and Mayhew (1999).