The Effect of Futures Trading on Cash Market Volatility: Evidence from the London Stock Exchange
AbstractThe stock market crash of October 1987 and the growing importance of index arbitrage and portfolio insurance helped to focus the attention of academics, practitioners and regulators on the possibly destabilising role of equity index futures on the underlying cash market. Although theoretical evidence on this question is somewhat ambiguous, empirical evidence, relating particularly to US markets, has been less equivocal: typically, no significant effect of futures trading has been found. This paper presents an analysis of daily stock price volatility on the London Stock Exchange for the period 1980-93. The measure of volatility produced is appropriate, given the distribution of returns and the time-varying nature of stock price volatility, and changes in monetary policy regime. The impact of futures on stock price volatility is measured within an augmented ARCH framework and the principal result is striking: rather than increasing volatility, index futures contracts are found to have reduced volatility significantly by around 17%.
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Bibliographic InfoPaper provided by Bank of England in its series Bank of England working papers with number 19.
Date of creation: Dec 1993
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- Hall, Joyce A. & Brorsen, B. Wade & Irwin, Scott H., 1989. "The Distribution of Futures Prices: A Test of the Stable Paretian and Mixture of Normals Hypotheses," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 24(01), pages 105-116, March.
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