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emf.sagepub.com/

Journal of Emerging Market Finance

emf.sagepub.com/content/7/3/263

The online version of this article can be found at:

Mispricing, Volume, Volatility

and Open Interest: Evidence

from Indian Futures Market

Vipul

Interdependence of the mispricing, volatility, volume and open interest of stock

futures and the volatility and volume of their underlying shares is examined in a

vector autoregressive framework. There is evidence of signifi cant mispricing that

persists for one day but is not explained by other variables. An increase in the

volatility of futures is generally followed by an increase in the volatility of the

underlying. The volatility and volume of futures and the underlying exhibit alter-

nating increase/decrease cycles with up to fi ve-day lags. These properties can be very

useful in forecasting the mispricing and the volatility, volume and open interest for

futures and their underlying shares. Futures mispricing does not change fi nancial

activities in any predictable manner.

JEL Classifi cation: G13

Keywords: Stock futures, mispricing, volatility, volume, open interest, VAR

1. Introduction

According to the ‘no arbitrage’ argument, the futures price should be the

price of the underlying (adjusted for the present value of the known future

cash infl ows) plus the cost of carry. If the actual futures price differs from this

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Journal of Emerging Market Finance, 7:3 (2008): 263–92

stock futures and their underlying shares. Mispricing of futures has important

implications for both hedgers and arbitrageurs. Whereas it makes hedging less

effective, it also provides profi t opportunities to the arbitrageurs. Therefore,

if the patterns of the occurrence and persistence of mispricing could be

discerned, it would greatly benefi t many market players. The mispricing of

stock index futures has been investigated in a number of studies in the past.

Individual stock futures have not been researched adequately because of

their recent introduction to the fi nancial markets. The present study extends

literature to bridge this gap. It is particularly useful because arbitrage is

relatively easier to set up for the stock futures (which have a single underlying

asset) as compared to the stock index futures.

Modest and Sundaresan (1983), Figlewski (1984), MacKinlay and

Ramaswamy (1988) and Yadav and Pope (1994) found signifi cant incon-

sistencies between the spot prices and the futures prices for stock indexes

which can be exploited by arbitrageurs. They also reported that the magnitude

of mispricing was greater during the periods when the implied volatility was

higher. An autocorrelated persistent mispricing between the spot and futures

prices was observed by MacKinlay and Ramaswamy (1988), Neal (1990),

Chung (1991) and other researchers in the US; Yadav and Pope (1994) and

Garrett and Taylor (2001) in the UK; Bowers and Twite (1985), Heaney

(1995) and Brailsford and Hodgson (1997) in Australia; Brenner et al. (1989)

in Japan; Lai and Marshall (2002) in Hong Kong; Puttonen (1993a and b) in

Finland; and Vipul (2004) in India. One plausible reason for this behaviour

was given as non-synchronous trading in the stock and futures markets.

However, subsequent research based on high frequency data, which controls

the non-synchronous error, still confi rmed numerous instances of mispricing

providing an opportunity of arbitrage (see MacKinlay and Ramaswamy 1988;

Brennan and Schwartz 1990; Hodgson et al. 1993; Yadav and Pope 1994).

Chung (1991), Klemkosky and Lee (1991), Miller et al. (1994), Butterworth

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Mispricing, Volume, Volatility and Open Interest / 265

Journal of Emerging Market Finance, 7:3 (2008): 263–92

with the fi ndings of Chen et al. (1995) and Chan and Chung (1993) for

stock index futures in the US, they found that the increased volatility

reduces mispricing. They did not fi nd a direct effect of the volatility on the

open interest. However, open interest rose for three days after a shock in the

pricing error. Chan and Chung (1993) found that prior to this phenomenon

an increase in the arbitrage spread leads to signifi cant increases in the cash

trading volume and the cash and futures price volatility. However, short sale

restrictions in the cash market attenuated this relationship. Brailsford and

Hodgson (1997) confi rmed a signifi cant effect of the volatility and trading

volume on the mispricing in Australia. Theobald and Yallup (1996) found

the mispricing to have an inverse relationship with the volatility but a positive

relationship with the trading volume for the UK stock index futures market.

Hemler and Longstaff (1991) and Merrick (1987) did not fi nd a signifi cant

relationship between the volatility and the mispricing. This leaves us with

mixed evidence about the relationship between mispricing, volatility, trading

volume and open interest in different markets and contexts.

To summarise, the mispricing in stock index futures is found to be closely

related to market activities refl ected in the volatility and volume of the futures

and their underlying. Some researchers fi nd that a higher volatility, due to its

associated violent movements of prices, leads to more mismatches between

the futures and their underlying and therefore, a higher mispricing. Others

fi nd that a higher volatility signifi es more activity which includes arbitrage

and therefore, leads to reduced mispricing. Higher volumes that refl ect

more activity in the market would lead to reduced mispricing. On the other

hand, if the volumes are driven by some speculative motive, then the higher

volumes would be associated with higher mispricing. Open interest being

directly related to the depth of the futures market also refl ects the activity

level and therefore, is expected to be linked to mispricing. These aspects have

been empirically investigated in the context of index futures but need to be

266 / Vipul

Journal of Emerging Market Finance, 7:3 (2008): 263–92

the futures based on a single share, the mispricing of stock futures provides

a good insight into the economic forces behind the pricing of futures. Stock

futures were introduced to derivatives markets quite recently all over the

world, and are not very liquid in many markets. This is one of the reasons

for the lack of research work in this area. Fortunately, in India this is not the

case. Stock futures, which were introduced in November 2001, have been

more popular than the options and index futures and are highly liquid. The

price discovery of futures can, therefore, be considered fairly effi cient. In

view of these facts, the Indian market provides a good opportunity to study

the mispricing of stock futures.

2. Futures Contracts in India

Futures were introduced to the Indian market in June 2000 when both the

National Stock Exchange (NSE) and the Stock Exchange, Mumbai (BSE)

started trading in index futures. Even earlier the Indian stock market was

accustomed to carry forward facilities (badla system) that had some charac-

teristics of futures contracts. Whereas NSE started with the trading of futures

on S&P CNX NIFTY Index, BSE introduced futures on the Sensex. The

average daily volume of trading in options and futures picked up from

Rs 20 million (about US$ 0.46 million) in June 2000 to cross Rs 87.90 bil-

lion (about US$ 2.04 billion) by November 2004 at NSE. Stock futures

were introduced in November 2001 by NSE and BSE on 41 equity shares.

NSE accounts for more than 97 per cent of the total turnover in the index

and stock-based derivative products in India. Stock futures are relatively

recent entrants to derivatives markets globally and have not attracted much

research interest. In fact the Indian derivatives market has been one of the

pioneers in stock futures. The NSE traded six most liquid stock futures are