Three essays on the Indian derivatives market

Abstract

The Indian derivatives market is one of the largest derivatives markets by volume in the world. The existence of liquid single stock options, single stock futures, and spot market along with very high retail participation makes the Indian financial market unique. In this thesis, we examine three different aspects of this market. The first essay examines the role of the derivatives market in attenuating left-tail risks anomaly. We find that the negative association between left-tail risk measure and future return is absent only in stocks with derivatives (DR stocks), indicating that derivatives trading hastens the diffusion of negative information into the stock prices. We also find evidence that the information generation role of derivatives contracts plays a primary role compared to the reduction of investor inattention and limits to arbitrage. Our results show that the existence of a derivatives market hastens the incorporation of negative news in the stock price. In the second essay, we examine investors’ behavioral biases and preferences in the options market near 52-Week high and low (52W-H/L).We document that as the stock price approaches 52W high (low), the risk-neutral skewness (RNS) and out-of-the-money (OTM) call volume decreases (increases), while OTM put volume increases (decreases). After crossing the 52W high (low), the RNS and OTM call volume increases (decreases), while OTM put volume decreases (increases). The effects are economically large and significant. Our findings provide evidence consistent with the anchoring theory of belief distortion near 52W-H/L. In the third essay, we examine if the embedded leverage of an instrument can impact relative trading activity across markets. Using option/stock, option/future, and future/stock volume ratios as measures of relative trading activity, we empirically find higher trading volumes in securities offering higher embedded leverage in general and especially during earnings announcements. Additionally, we find that embedded leverage incentivizes information generation thereby reducing future price uncertainty. Taken together, our findings show that derivatives improve information flow and they do so by making it easier to trade. Therefore, sometimes, they can also amplify biases. Our results provide valuable insights for investors, policymakers, and regulators.