The remainder of the paper is organized as follows. Section II reviews the past literature on the subject of the futures index activity– cash market volatility relationship.
Section III describes the data and methodology employed. Section IV presents the empirical results. Section V summarizes the findings of the study.
II. Prior Research
Opponents of speculative trading activity have generally argued that increased trading in futures leads to unnecessary price volatility in the underlying cash markets. Some
researchers have suggested that the participation of speculative traders in systems which allow high degrees of leverage lowers the quality of the information in the market
[Figlewski 1981; Stein 1987]. Cox 1976, among others, noted that uninformed traders could play a destabilizing role in cash markets. Others, more generally, have
questioned the role of futures markets as representing an institutional alternative for accurate price forecasting [Martin and Garcia 1981; Kolb et al. 1983].
On the other hand, it also has been suggested that the futures markets have become an important medium of price discovery in cash markets [Schwarz and Laatsch 1988].
Several papers have argued that trading in these markets improves the overall markets’ depth and informativeness [Powers 1970], enhances market efficiency [Stoll and Whaley
1988], increases market liquidity [Kwast 1986], and compresses cash market volatility [Danthine 1978; Kyle 1985].
Theoreticians have suggested that cash market volatility may be influenced not just by speculative trading volume, but also the number of speculators. For instance, Clark 1973
related daily price changes and the number of within-day price changes, and suggested that the variance of price changes is directly proportional to the number of traders.
Tauchen and Pitts 1983 developed a model wherein the price change over an interval represents the average of the changes in the speculators’ reservation prices over the
interval. The greater the number of terms in this average i.e., the greater the number of speculators, the greater the likelihood that the effects of the changes in reservation prices
will be washed out. More recently, Osler 1995 demonstrated that a rise in the number of speculators may result in lower levels of cash market volatility. Osler suggested that
speculators drive a wedge between incoming information and cash market pricing, smoothing the effects of shocks to the fundamental determinants of asset prices.
There is a great deal of evidence regarding the general impact of futuresoptions trading on the volatility of equity markets. The evidence generally indicates that derivative trading
activity either adds to the stability, or does not impact the volatility of cash markets [Santoni 1987; Edwards 1988; Skinner 1989; Schwert 1990; Bessembinder and
Seguin 1992; Choi and Subrahmanyam 1994; Chatrath et al. 1995; Darrat and Rahman 1995]. However, it is notable that studies which have examined the futures
trading activity–spot market volatility relationship have taken an aggregated approach to measuring futures trading activity. For instance, Bessembinder and Sequin 1992 exam-
ined the significance of contemporaneous and lagged futures volume or open interest decomposed into expected and unexpected components in their volatility equations.
Such studies are unable to shed light on whether certain groups of traders, more than others, pose a threat to cash market stability andor impede the price discovery process.
Nor are these studies able to indicate the role of trader numbers in price variability. These important gaps are filled by the current paper.
Speculative Activity and Stock Market Volatility 325
III. Data and Empirical Model
