Speculative Activity and Stock Market Volatility
Arjun Chatrath, Sanjay Ramchander, and Frank Song
This paper examines the impact of speculative futures trading on the volatility of the SP 500 index. The empirical approach taken allows for more specific inferences regarding
whether speculators ought to be targeted for regulation. There is no evidence that speculators contribute to market volatility. Although there are strong indications that
futures open interest is contemporaneously related to cash market volatility, volatility and speculative are only weakly related. Further, there is an absence of causality between cash
market volatility and speculative commitments. The study also distinguishes between a possible impact of contract size and number of traders. We document a positive contem-
poraneous relationship between cash market volatility and the size of the commitments of large speculators. However, there is no evidence that the changes in the number of
speculators or the size of their holdings result in increased levels of interday or intraday cash market volatility. Based on the findings, the proposals for further regulation directed
at stock index speculation seem unwarranted.
© 1998 Elsevier Science Inc. Keywords: Volatility; Speculations
JEL classification: G1
I. Introduction
Observers of financial markets have often questioned the role of futures trading in the volatility of stock prices [see, for instance, the Brady Commission Report 1988 and the
U.S. Securities and Exchange Commission SEC Report 1988]. Central to their con- cerns is the steady rise in the popularity of stock index futures. The average futures open
interest on the most popular SP 500 index rose from 54,611 contracts in 1985, to over 193,400 contracts in 1995. Although much of the interest in stock index futures may be
School of Business Administration, University of Portland, Portland, Oregon Department of Finance, Insurance and Real Estate, Mankato State University, Mankato, Minnesota Department of Economics, Cleveland
State University, Cleveland, Ohio and School of Economics and Finance, University of Hong Kong, Hong Kong. Address correspondence to Frank Song, Department of Economics, Cleveland State University, Euclid
Avenue at East 24th Street, Cleveland, OH 44115.
Journal of Economics and Business 1998; 50:323–337 0148-6195 98 19.00
© 1998 Elsevier Science Inc., New York, New York PII S0148-61959800007-1
attributed to the growth in the hedging activities of institutional traders, index futures have also attracted the participation of a variety of other traders, including index arbitrageurs,
scalpers, and day traders. Despite their relatively minor participation in index futures, speculators and small
traders are often singled out as major contributors to volatility in stock markets. It has been argued that the leverage afforded in futures markets attracts speculators in search of
short-term gains, and there are concerns that these traders may be causing or exacerbating stock market volatility. For instance, the SEC described the role of futures in the 1987
crash as follows:
“ . . . The existence of futures on stock indexes and the use of various strategies involving ‘program trading’ were a significant factor in accelerating and exacerbating the decline.” [U.S. Securities and
Exchange Commission Report 1988, pp. 3–11]
Such arguments have translated to a call for increased regulation, especially since the crash of October 1987, whereby speculators and small traders have been the target for
stricter control via measures such as increased margin requirements, program trading curbs, and through the generally more active governance of the Commodity Futures
Trading Commission CFTC [for instance, see the U.S. Securities and Exchange Com- mission Report 1988, p. 65; the Brady Commission Report 1988, p. 66].
1
This study provides further evidence on whether or not futures speculation leads to greater stock market volatility. Whereas prior studies on the impact of futures trading have
generally examined the derivative trading-cash volatility relationship in the context of aggregate volume or open interest [for instance, see Bessembinder and Seguin 1993;
Darrat and Rahman 1995], this study employs disaggregated futures open interest data which allows us to make more specific inferences regarding whether speculators ought to
be targeted for further regulation. We present empirical evidence on the relationship between alternate measures of cash market volatility in the SP 500 index, and the
commitment of speculators, the number of speculators, and the size of their commitments. Position limits and margin requirements in futures markets including equity indexes
have been altered widely and often, possibly to contain speculator participation in both, their numbers and contractual holdings, though it is far from clear that speculators have
a destabilizing influence on markets.
2
The examination of the relationship between volatility and speculator numbers and average contract size should go a long way to
addressing this matter. The paper also evaluates the role of excessive speculation in cash market volatility, where excessive speculation is defined as the commitments of specu-
lators over and above that which is required to fill hedging imbalances.
The results suggest only a weak positive contemporaneous relationship between cash volatility and the commitments of speculators. In fact, we found that speculative com-
mitments have a relatively smaller influence on cash volatility as compared to other commitments. Moreover, there is little evidence to indicate that the positions of specu-
lators or their numbers lead cash market volatility. Based on the findings, the proposals for further regulation directed at stock index speculation seems unwarranted.
1
The surveillance powers of the CFTC are the combined product of several enactments and amendments, including the Commodity Exchange Act 1936, 1968, the Commodity Futures Trading Commission Act of
1974, and the Futures Trading Acts of 1978, 1982. For details of the current regulatory measures and proposals, see the Committee on Banking, Finance, and Urban Affairs 1988.
2
There is no evidence that suggests the effectiveness of margin requirements in reducing cash market volatility [see Seguin and Jarrell 1993].
324 A. Chatrath et al.
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
