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The Effect of Futures Trading on Cash Market Volatility: Evidence from the London Stock Exchange

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  • Gary Robinson
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    Abstract

    The 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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    File URL: http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/1993/wp19.pdf
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    Bibliographic Info

    Paper provided by Bank of England in its series Bank of England working papers with number 19.

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    Date of creation: Dec 1993
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    Handle: RePEc:boe:boeewp:19

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    1. Kawai, Masahiro, 1983. "Price Volatility of Storable Commodities under Rational Expectations in Spot and Futures Markets," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 24(2), pages 435-59, June.
    2. 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.
    3. Culter, D.M. & Poterba, J.M. & Summers, L.H., 1990. "Speculative Dynamics And The Role Of Feedback Traders," Working papers 545, Massachusetts Institute of Technology (MIT), Department of Economics.
    4. Engle, Robert F, 1982. "Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation," Econometrica, Econometric Society, vol. 50(4), pages 987-1007, July.
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