The Effect of Currency Futures on Volatility of Spot Exchange Rates: Evidence from India

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1 International Journal of Economic Research ISSN : available at http: Serials Publications Pvt. Ltd. Volume 14 Number The Effect of Currency Futures on Volatility of Spot Exchange Rates: Evidence from India P. Sakthivel 1, Krishna Reddy Chittedi 2, Daniel Sakyi 3 and V. Vijay Anand 4 1 Assistant Professor, Department of Commerce and Management, Srinivasa Ramanujan Centre, SASTRA University, Kumbakonam, Thanjavur, Tamilnadu, India. sakthivel@mba.sastra.edu 2 Assistant Professor, School of Economics, University of Hyderabad, Telangana, India. krc@uohyd.ac.in 3 Senior Lecturer, Department of Economics, Kwame Nkrumah University of Science and Technology (KNUST), Private Mail Bag, Kumasi, Ghana. dsakyi.cass@knust.edu.gh 4 Assistant Professor, School of Management, SASTRA University, Thanjavur, Tamilnadu 427 Abstract This study empirically investigates the effect of currency derivative trading on volatility in spot exchange rates for GBP/INR, JPY/INR, and EURO/INR. Using daily spot exchange rates from October 20 th 2005 to 30 th October, 2016, ARCH-LM test, GARCH model and GJR GARCH model were applied to the data set. The result reveals that the effect of recent market news on current volatility of exchange rate returns increases and reduces the previous day s news influencing them during post currency futures. The results from GARCH and GJR GARCH models showed that currency futures trading reduces volatility in spot exchange rate returns of JPY/INR and GBP/INR and increases volatility of exchange rate returns of EURO/ INR during post currency futures period. The result further suggests that there was an asymmetric effect in volatility of spot exchange rate returns. Keywords: Volatility, GARCH, Currency Futures. 1. Introduction In , India underwent structural changes in foreign exchange market which experienced paradigm shift in rupee full convertible on current account. Further, the capital movement and number of foreign trade across nations have increased after structural changes and have resulted in higher volatility of foreign exchange market in India. In recent times, foreign exchange market is highly volatile and therefore the exchange rate risk is an important concern for both exporters and importers. Higher market volatility has International Journal of Economic Research

2 P. Sakthivel, Krishna Reddy Chittedi, Daniel Sakyi and V. Vijay Anand an adverse impact on trade and investment, price of products and profit for both exporters and importers. To reduce foreign exchange risk with the help of hedging, Reserve Bank of India (RBI) has permitted to introduction of currency futures contract on US dollar/inr on 29 th August, 2008 at National Stock Exchange of India (NSE) and on 1 st October 2008 at Bombay Stock exchange (BSE). Futures trading on currency in three new pairs namely JPY/INR, GBP/INR and EUR/INR were commenced on 1 st February 2010 at NSE. The impact of inception of derivative trading on spot market volatility has been an attractive topic for investors, traders, and academicians because it implications for hedging and speculation. One research group of studies argued that inception of derivative trading stabilizes the foreign exchange markets as well as in equity markets by reducing its volatility (Butterworth, 2000; Bologna, 2002; Santoshkumar et. al, 2011; Arif Oduncu, 2011; and Ashish Kumar, 2015; Antoinmu, 1995). These studies show that futures trading have reduced volatility of foreign exchange markets as well as in equity markets due to speculators migration from spot to futures market and improved in market efficiency. Other group of studies however noted that inception of trading on currency futures destabilize foreign exchange markets as well as in equity markets by increasing volatility (Finglewski, 1981; Clifton, 1985; Chatrath et. al., 1996). These studies reveal that volatility in spot market has increased due to excessive speculative investors in derivative market. In the light of this background, it is imperative to verify the effect of inception currency futures trading on spot exchange rates volatility of Japanese Yen/INR, Euro/ INR and British Pond/INR. 2. Empirical Review of Literature Dhananjay (2012) explored the effect of exchange traded currency futures on exchange rate volatility in India. The study uses time series techniques like unit root test, ARCH-LM test and GARCH model. Daily spot exchange rate of EURO/INR was collected from January 2 nd, 2008 to 31 st December 2011 and used in analysis. The result reveals that introduction of currency derivative trading has no impact on volatility of spot exchange rate returns. Singh and Tripathi (2015) reports reveal in their studies that the volatility of spot exchange rate returns (EURO/ INR) has reduced after introduction of currency derivative trading in August 2008 by National Stock Exchange of India. They used daily spot exchange rate of EURO/INR from April 2006 to December 2014 to explore the effect of inception of currency derivative trading on of exchange rate volatility in India. They conclude that futures trading enhanced speed of recent news on volatility of spot foreign exchange market and also improved market efficiency during post currency derivatives period. Santosh et. al., (2011) also claim that currency futures trading have reduced asymmetric volatility of spot currency market in India. The GARCH, EGARCH and TARCH techniques were used for analysis. Daily spot exchange rate of US Dollar/INR was used and entire data divided into two periods; before introduction of currency futures (from August 2000 to August 2008) and after introduction of currency futures in NSE (from August 2008 to August 2010 to capture their effect on volatility in spot exchange rates. The result reveals that there was an altered significantly structure of volatility in foreign exchange market in India. In related study, Arif (2011) verified the effect of inception of currency futures on foreign exchange market volatility in Turkey. Daily spot exchange rate of Euro/US dollar was sourced from Central Bank of International Journal of Economic Research 428

3 The Effect of Currency Futures on Volatility of Spot Exchange Rates: Evidence from India Turkey for period February 2002 to February The result suggests that rate of information arrival into market has increased and it incorporates to current exchange rates more quickly than before the inception of futures trading. The result from the study shows that the volatility foreign exchange market in Turkey has reduced after commencement of currency futures period. Ashish (2015) used time series techniques such as unit root test, ARCH-LM test, and GARCH model and daily spot exchange rate of EURO/INR from 1 st January, 2006 up to 30 th September, 2014 to verify effect of inception of currency futures on exchange rates volatility in India. The result shows that there has been a decline in volatility of spot foreign exchange market in India during post currency futures period. Anuradha (2010) employed alternative time series estimation techniques like VAR and reports that currency futures trading has no influence on underlying spot exchange rate volatility in India. He obtained the daily closing exchange rates of US dollar/ INR from NSE for period of August 2008 to August The result shows that arrival news first aggregated into currency futures market and then transmitted to spot foreign exchange market. Jochum and Kodres (1998) used SWARCH model and found that inception currency futures trading has no significant impact on volatility of spot exchange rates returns. Daily spot exchange rates of Mexican peso and the Brazilian were collected from January 1 st, 1995 to February 28 th, 1997 for analysis. They concluded that volatility of spot exchange rate returns do not influenced by currency futures market. Adrangi and Chatrath (1998) reveal in their study that inception of currency derivative trading destabilizes spot foreign exchange market by increasing volatility. Drimbetas et. al., (2006) however argued that volatility of spot market has declined during post inception of currency futures period due to speculators actively trading in futures market than spot market. Daily data from ASE index 20 was collected from August 1997 to April 2005 to verify the effect of inception futures contract on equity market volatility. The result suggests that the volatility of ASE index 20 has declined during post inception futures period. The above empirical evidences have found mixed results both in India and outside of India. Therefore the present study re-investigates the effect of inception of futures trading on spot currency market volatility in India. Aim of the Study In the light of this background, the study sought to achieve the following objectives. 1. To discover the effect of inception of currency futures on volatility of spot exchange rates namely JPY/INR, GBP/INR and EURO/INR. 2. To find out whether currency futures trading has altered arrival of news into market or not during post currency futures period. Data Description 3. Data and Methodology The daily data was obtained from official website of Reserve Bank of India. Daily spot exchange rates of Japanese Yen/INR, British Pond/INR and EURO/INR were taken from October 20 th 2005 to 30 th 429 International Journal of Economic Research

4 P. Sakthivel, Krishna Reddy Chittedi, Daniel Sakyi and V. Vijay Anand October, 2016 to analysis the effect of inception of currency derivative trading on exchange rates volatility in India. The entire data period was divided into two sub period; pre currency futures introduction (October 20 th, 2005 to 30 th January, 2010) and post currency futures introduction (February 1 st, 2010 to 30 th October, 2016). All data was expressed in natural logarithms to avoid any unreliable results. 4. Methodology Unit root tests were conducted to check whether the data is stationary or not. Time series data like daily spot exchange rates must be stationary before using them in econometric model. Stationary implies the invariant of mean; variance and covariance of series are stationary. Apply of non-stationary series in estimation of econometric model may misleads inferences. So it becomes essential to test the stationary of the series. The stationarity model proposed by Dickey and Fuller (1979) to ascertain the unit root of time series can be written as Dy i = s + j y + q D y + e (1) 0 1 t -1 i t -i t i = 1 The non rejection of the null hypothesis q i = 0, implies that data contain a unit root and is nonstationary. On the other hand the rejection of the null hypothesis q i = 0, means that the data does not contain a unit root and hence is stationary. The Generalized ARCH (GARCH) Model To investigate the effect of inception of currency derivative contact on volatility of spot exchange rate returns, generalized autoregressive conditional heteroscedasiticity (GARCH) was employed. Foreign exchange market is often characterized by certain time series properties such as mean revision, leverage effects, leptokurtosis, persistence volatility, and volatility clustering. The GARCH related estimation techniques are mainly developed to capture these characteristics that are generally related with foreign exchange market. GARCH model is specified as follows. h t q 2 0  1 t - 1 i = 1 International Journal of Economic Research 430 p  = s + d e + q In equation (2) d 1 and q j are news coefficients that explain how recent and previous news impacts conditional volatility of spot exchange rate returns. d 1 is coefficient that explains the effect of recent market shocks on current volatility of spot exchange rate returns. q j is persistence co-efficient that explains the effect of the previous day s shocks on current volatility. A dummy variable was introduced into GARCH conditional variance equation to explore the effect of currency futures trading on volatility of spot exchange rates for JPY/INR, GBP/INR and EURO/INR. The modified GARCH model is specified as follows p  j = 1 2 t 0 1 t -1 i t - j j h t - j h = d + f e + q h + g 1 dv (3) where, dv is the dummy variable. Negative and significant co-efficient of the dummy (g 1 ) implies the there is a decline in volatility of spot exchange rate returns during post currency futures period. On the other (2)

5 The Effect of Currency Futures on Volatility of Spot Exchange Rates: Evidence from India hand, positive and significant co-efficient of the dummy (g 1 ) indicates there is an increase in volatility of spot exchange rate returns due to inception of currency futures. 5. GJR GARCH Model The asymmetric model was developed by Gltosan, Jagannathan and Runkle, (1993), hence name GJR Generalized auto regressive conditional heteroscedasiticity (GARCH). The GJR GARCH model mainly captures asymmetric effects which is present in time series data. The GJR Generalized auto regressive conditional heteroscedasiticity (GARCH) model was employed to analysis the effect of currency futures trading on spot exchange rate volatility. To capture the effect of currency derivative trading, a dummy variable was included in variance equation. The modified GJR GARCH model is written as follows. h t q p r  j t - 1  j t - 1  1 t -1 t-1 i j = i i = 1 k = 1 = q + q e + p h + g I e + l DV (4) In the equations (4) q j, p i, and g 1 are parameters. DV is dummy variable. l i is coefficient of dummy variable which can either significantly positive or negative. g 1 is asymmetric coefficient. 6. Results and Discussion To confirm whether the data is stationary or not, ADF and PP tests were conducted. The results from the stationarity tests reported in table 1. ADF and PP tests statistics reveals that all log series of spot exchange rates of JPY/INR, GBP/INR and EURO/ INR were non stationary at level form. However, they were stationary at first difference. Table 1 Unit root Test Statistics Name of Series ADF (Level) ADF (1 st Difference ) PP (Level) PP (1 st Difference) JPY/INR * * GBP/INR * * EURP/INR * * * indicates 1 percent level of significance The descriptive statistics is presented in Table 2. The mean returns of JPY/INR and EURO/ INR were positive and that of GBP/INR was negative during both pre currency and post currency futures periods. The standard deviation of EURO/INR was higher as compared to JPY/INR and GBP/INR during post currency futures. It shows that there was higher volatility of spot exchange rate returns of EURO/INR. Jarque-Bera test reveals that all returns series of JPY/INR, EURO/ INR and GBP/INR follows non-normal distribution since null hypothesis has rejected. Lagrange Multiplier (LM) test was used to confirm the presence of series correlation of variance in returns series of JPY/INR, EURO/INR and GBP/INR. LM test shows that there was ARCH effect in all returns series. 431 International Journal of Economic Research

6 P. Sakthivel, Krishna Reddy Chittedi, Daniel Sakyi and V. Vijay Anand Table 2 Descriptive Statistics Pre Currency Futures Period Name of Series Mean S-D Skewness Kurtosis J.B Test LM Test JPY/INR GBP/ INR EUR/INR Post Currency Futures Period JPY/INR GBP/ INR EUR/INR Whole Period JPY/INR GBP/INR EUR/INR The standard GARCH model was used to confirm whether currency futures trading have altered arrival news into spot market or not during post currency futures period. Table 3 presents result of GARCH model. Table 3 Results of GARCH Model Estimation Pre Currency Futures Period Name of Series d 0 Constant d I (Arch coefficient) q j (Garch coefficient) d i + q j JPY/INR 0.05e * * 1.18 (1.864) (3.372) (7.882) GBP/INR (1.427) EUR/INR 0.03e01 (1.643) JPY/INR (1.9925) GBP/ INR 0.0e345 (1.2263) EUR/INR (1.6322) * imply that 1 % level of significance * (4.773) * (2.327) Post Currency Futures Period * (2.238) * (5.884) * (4.782) * (5.743) * (10.437) * (7.991) * (7.217) * (7.385) The result reveals that recent news greatly impacts current volatility of spot exchange rate returns since the ARCH coefficient (d i ) for JPY/INR and GBP/INR are positive and significant. The value of ARCH coefficient for JPY/INR slightly rose from to from before currency futures to after currency futures. It suggests that effect of recent news on current volatility of spot exchange rate returns of JPY/INR has increased and they incorporate to current exchange rates more quickly than before the inception of currency derivative trading. International Journal of Economic Research

7 The Effect of Currency Futures on Volatility of Spot Exchange Rates: Evidence from India The value of GARCH coefficient (q j ) for JPY/INR declines to which confirms the effect of previous day s news on current volatility of spot exchange rate returns decreases during post currency futures as compared to pre currency futures. Similar results were observed in the case of GBP/INR. However, the value ARCH coefficient for EURO/INR has reduced from to from pre currency futures to post currency futures. It implies that impact of recent news on current volatility in exchange rate returns of EURO/INR has decreased. This result suggests that previous day s news play a major role in determining current volatility of EURO/INR. The result also reveals that the sum of both coefficients (d i + q j ) for JPY/INR and GBP/INR is more than 1 during pre currency futures period. It therefore implies that there has been persistence volatility of spot exchange rate returns. However, the volatility persistent declined during post currency futures. To discover the effect of inception of currency derivative trading on spot exchange rates volatility, GARCH model was used. Table 4 shows result of the GARCH model. The result reveals that coefficients of dummy variable (g 1 ) were negative and statistically significant for JPY/INR and GBP/INR indicating that there has been a decline in volatility of exchange rate returns of JPY/INR and GBP/INR during post currency futures period. This is due to fact that currency futures trading enhanced rate of information arrival into market and speculators migration from spot to futures market. However, currency futures increased volatility of exchange rate returns of EUR/INR during post currency futures period, since the coefficient of dummy variable (g 1 ) was positive and significant. Table 4 Statistics of GARCH Model Estimation with DummyVariable Whole Period Name of Series d 0 constant d I (Arch coefficient) q j (Garch coefficient) g 1 (Dummy) JPY/INR 0.05e02 (0.992) GBP/INR (0.6721) EUR/INR (2.1160) * imply that 1 % level of significance * (3.779) * (5.563) * (3.832) * (6.875) * (11.563) * (5.892) * (-2.965) * (2.743) * (3.991) To check the effect of inception of currency derivative trading on volatility of exchange rate returns of EUR/INR, JPY/INR and GBP/INR, GJR GARCH technique was used. The result of GJR GARCH model is presented in table 5. The result from GJR GARCH reveals that coefficient of asymmetric was positive and significant even though a dummy variable is introduced in variance equation. This result suggests that presence of asymmetric effect in volatility of spot exchange rate returns. The result further shows that currency futures trading reduced volatility in exchange rate returns of JPY/INR and GBP/INR. However, volatility of exchange rate returns of EURO/INR has increased during post currency futures period. 7. Major Findings and Conclusion The effect of currency derivative trading on foreign exchange market volatility in India has been an interesting topic for investors, traders, and academicians because it implications for hedging and speculation. Firstly, 433 International Journal of Economic Research

8 P. Sakthivel, Krishna Reddy Chittedi, Daniel Sakyi and V. Vijay Anand Table 5 Statistics of GJR GARCH Model estimation with Dummy Variable Whole Period Name of Series q 0 constant q j (Arch coefficient) π i (Garch coefficient) g 1 (asymmetric coefficient l 1 Dummy JPY-INR (2.324) GBP/-INR 0.03e02 (1.865) EUR-INR 0.284* (2.643) * (4.990) * (2.663) * (3.732) * (8.8329) * (7.364) * (13.843) * (2.472) * (2.721) * (3.743) * (-2.881) * ( * (3.560) * imply that 1 % level of significance this paper empirically investigates the effect of inception of currency futures trading on spot exchange rates volatility in India. Secondly, the study explores whether currency derivative trading has altered flow of news into spot market or not during post currency futures period. Daily spot exchange rates of GBP/INR JPY/ INR, and EURO/INR from October 20 th 2005 to 30 th October, 2016 were used for the analysis. The time series estimation techniques such as unit root test, ARCH-LM test, GARCH model and GJR GARCH model were employed. The result reveals that the impact of recent news on current volatility of spot exchange rate returns increases and reduces the previous day s news influencing them during post currency futures. The result from GARCH family techniques show that inception currency futures reduced volatility in spot exchange rate returns of Japanese Yen/INR and British Pond/INR and it increased volatility of exchange rate returns of INR/ Euro during post currency futures period. The result further shows that there was an asymmetric effect in volatility of spot exchange rate returns. References Antoniou, A and P Holmes, (1995), Futures Trading, Information and Spot Price Volatility: Evidence for the FTSE-100 Stock Index Futures Contract using GARCH Journal of Banking & Finance, Vol.19 No.1 pp, Anuradha guru (2010), The Effect of Currency Trading on Volatility of Spot Exchange Returns, Indian Economic Review, Vol. 35, No.1, pp Arif Oduncu (2011), The Impact of Currency Derivative Trading on Turkish Currency Market, Working Paper Series of Central Bank of the Republic of Turkey, pp Ashish Kumar, (2015), Impact of Currency Futures on Volatility Exchange rate of Euro-INR, Paradigm, Vol. 19, No.1 pp Butter worth Darren (2000), The impact of Introduction of the Index Futures Trading on Underlying Stock Index Volatility in the case of the FISE Mid 250 contract, Journal of Financial Economics, Vol. 7, pp Chatrath A, Song, F and., Ramchander, S, (1996), The Role of Futures Trading Activity in Exchange Rate Volatility. Journal of Futures Markets, Vol. 16, pp Dhananjay Sahu (2012) Impact of Currency Futures on Spot Exchange rate Volatility in India Research Journal of Finance and Accounting Vol 3, No 7, pp Drimbetas, Evangelos, Sariannidis, and Nikolaos (2007), The Effect of Derivatives Trading on Volatility of the Underlying Asset: Evidence from the Greek stock market, Applied Financial Economics,Vol. 17, Vol. 2, pp International Journal of Economic Research 434

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