Impact of the introduction of derivatives on underlying volatility: evidence from India

Abstract

This article investigates the changes in volatility in the Indian stock market after the introduction of derivatives. There is strong evidence of a reduction in the volatility of the underlying shares after the introduction of derivatives. This is largely attributable to a reduced persistence in the previous day's volatility. However, the interday unconditional volatility of the equity index increases. This contradiction is explained by an increased correlation between the prices of its constituent shares caused by arbitrage transactions in the cash market. This study reconciles the apparent contradictions in the results of earlier studies, some of which report an increase, as against many others which report a decrease, in the volatility on introduction of index futures.