Do individual index futures investors destabilize the underlying spot market?

Abstract

This paper investigates the impact of introducing index futures trading on the volatility of the underlying stock market exploiting a unique setting in which individuals are the most prominent trader type in the futures markets. The dominance of presumably uninformed individuals in the futures markets enables us to investigate the destabilization hypothesis more directly than previous studies do and (2) to provide evidence for or against the influence of individuals trading in index futures on spot market volatility. To overcome econometric shortcomings of the existing literature we employ a Markov-switching-GARCH approach to endogenously identify distinct volatility regimes. Our empirical evidence for Poland surprisingly suggests that the introduction of index futures trading does not destabilize the spot market. This finding is confirmed for three stock market indices and its robustness is substantiated by results from a stock market index which is not underlying futures contracts.

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