Equity index futures trading and stock price crash risk: Evidence from Chinese markets

• Date: 01 November 2018
• Author: Jinyu Liu,Rui Zhong
• DOI: http://doi.org/10.1002/fut.21933
• Published date: 01 November 2018

Received: 17 August 2017

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Revised: 28 April 2018

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Accepted: 1 May 2018

DOI: 10.1002/fut.21933

RESEARCH ARTICLE

Equity index futures trading and stock price crash risk:

Evidence from Chinese markets

Jinyu Liu

1

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Rui Zhong

2

1

Department of Investments, School of

Business and Finance, University of

International Business and Economics,

Beijing, China

2

Department of Accounting and Finance,

UWA Business School, University of

Western Australia, Crawley, Western

Australia, Australia

Correspondence

Rui Zhong, Department of Accounting

and Finance, UWA Business School,

University of Western Australia,

35 Stirling Highway, Crawley, WA,

6907, Australia.

Email: ruizhong@outlook.com

Funding information

National Natural Science Foundation of

China, Grant/Award Number: 71501197;

Central University of Finance and

Economics

Equity index futures are often blamed for exacerbating equity price crash risk

although there is little empirical evidence to support the accusation in the

literature. We find that Chinese equity index futures trading significantly

reduces stock price crash risk. This negative relationship is strengthened by

institutional ownership and weakened by a controlling shareholders’incentive

to elude external monitoring, such as the divergence of control and cash‐flow

rights of dominant shareholders, the block holdings of the largest shareholders,

and state ownership. Our findings reveal the positive externality of financial

derivative innovation on equity market stability.

KEYWORDS

equity index futures, information hoarding, ownership structure, stock price crash risk

JEL CLASSIFICATION

D53, D82, G13, G23

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INTRODUCTION

Equity index futures—one of the most successful financial innovations in recent decades—are designed to facilitate the

hedging or transfer of equity market risk, including the risk of large stock price crashes. However, equity index futures

markets are sometimes accused of exacerbating volatility in the corresponding stock market although there is little empirical

evidence to support the accusation in financial economics. In this study, we investigate the impact of equity index futures

trading on stock price crash risk using the introduction of Chinese Security Index 300 (CSI300) index future (hereafter, IF300)

as a natural experiment. We choose the equity index futures in China rather than in developed countries for three main

reasons. First, in developed markets the coexistence of various financial derivatives (e.g., single stock futures, options, and

credit default swaps [CDSs]) increases the difficulty of isolating the impact of equity index futures on spot price, whereas the

IF300 is the only financial derivative in Chinese financial markets during our sample period.

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Second, short‐selling is very

difficult in Chinese equity market, which mitigates the impact of short sellers on capitalizing negative information into stock

prices and therefore provides an ideal environment to examine the influence of equity index futures’short‐sale flexibility on

the revelation of firm‐specific information. Third, since the IF300 is one of the most liquid equity index futures in emerging

markets, it alleviates the impact of illiquidity on the empirical evidence we document in this study.

J Futures Markets. 2018;38:1313–1333. wileyonlinelibrary.com/journal/fut © 2018 Wiley Periodicals, Inc.

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Since April 2015, there are three equity index futures in China: the IF300, IH50, and IC500. The IH50 and IC500, whose referenced equity indices are the SSE50 and CSI500, respectively, were

initiated on April 16, 2015. The SSE50 consists of the top 50 largest stocks listed on the Shanghai Stock Exchange. The CSI300 consists of the top 300 largest and most liquid stocks listed on both the

Shanghai and Shenzhen Stock Exchanges. Most of the stocks included in the SSE50 are also included in the CSI300. Therefore, we use the IF300 in our analysis.

We define stock price crashes as extremely negative firm‐specific stock returns without correspondingly large public

news, which is rare but leads to huge losses once it occurs. The most prevailing explanation is the negative information

hoarding argument. Specifically, managers have a tendency to hide bad news because of the potential adverse impact

on their compensation (Benmelech, Kandel, & Veronesi, 2010; Kim, Li, & Zhang, 2011a, 2011b), career concerns, and

empire building (Ball, 2009; Kothari et al., 2009). The accumulated negative information tends to overvalue equity price,

thereby creating a bubble. Once the accumulated bad news exceeds the tipping point, all bad news will flow to the

equity market simultaneously, resulting in a sudden and drastic stock price decline (Jin & Myers, 2006). In a similar

vein, the influence of equity index futures trading on firm‐specific stock price crash risk relies on its impact on the

efficiency of revealing and capitalizing this hidden bad news in equity prices. Closely related findings are contradictory

regarding the impact of equity index futures trading on the efficiency of information flow in the equity market. On one

hand, Cox (1976), Bessembinder and Seguin (1992), and Campbell, Lettau, Malkiel, and Xu (2001) find that equity index

futures improve spot market information efficiency by attracting informed investors to trade spot assets, which results

in a lower likelihood of experiencing extremely negative firm‐specific stock returns for equity index component stocks.

On the other hand, high leverage and low transaction costs of equity index futures induce uninformed investors to

engage in index arbitrage between equity index futures and spot assets (Grossman, 1989; Grossman & Miller, 1988),

which reduces the information efficiency of spot markets and suggests an increase in stock price crash risk. Therefore,

how equity index trading affects component stock price crash risk is essentially an empirical question.

To investigate the influence of equity index futures trading on firm‐specific stock price crashes, we use the Chinese

Securities Index 300 (CSI300) component stocks, which are included in the CSI300 during our sample period

2005–2014.

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We adopt a dummy variable (IF) that equals one to indicate the presence of equity index futures trading on

component stocks and zero otherwise. We use the negative skewness of firm‐specific daily returns as a primary measure

and the down‐to‐up volatility (DUVOL) as an alternative measure of stock price crash risk. Additionally, we use a

dummy variable to indicate the presence of actual crashes in a year for a firm.

We find a significantly negative impact of equity index futures trading on component stocks’price crash risk in the

future, supporting the argument that theintroduction of equity index futuresmarket accelerates the process of uncovering

and capitalizingfirm‐specific bad news in stock price, which results in a lower likelihood of experiencing stockprice crash

in future. This negative relationship is more pronounced after adopting Heckman’s selection model to alleviate selection

bias for component stocks. Moreover, we find that the significantly negative relationship between equity index futures

trading and stock price crashes is robust after (a) expanding component stocks to all stocks that were included in the

CSI300 for at least 1 year during our sample period and (b) incorporating possibly omitted variables that simultaneously

affect both component stock selections and stock price crashes. Further, usingthe aggregated trading volume of IF300 in a

year as an alternativeproxy for equity index futures trading activities, we find that the aggregated trading volume of IF300

in a year is negatively related to the likelihood of experiencing firm‐specific future price crashes, which strengthens the

negative impact of equity index futures trading on the likelihood of occurring stock price crashes.

To evaluate the economic significance of the impact of equity index futures trading on firm‐specific crash risk, we

find that the commencement of IF300 trading reduces negative skewness and DUVOL by about 0.22 and 0.12 with

approximate means of −0.70 and −0.51, respectively, in our sample. Further, we employ an indicator to identify crash

years in which there is one or more than one weekly return that exceeds 3.2 standard deviations below the means of

firm‐specific returns. We find that the initiation of IF300 reduces the actual probability of experiencing a crash year by

approximately 23%.

After establishing the negative relationship between equity index futures trading and firm‐specific stock price crash

risk, we investigate the possible channels and mechanism by examining the impact of informed traders on this negative

relationship. In particular, we break down informed traders into two groups, institutional investors and other informed

investors. Since we do not have the ownership information of informed individual investors, we start by examining the

impact of institutional ownership (IO). We find that the negative impact of IF300 on firm‐specific price crashes is more

pronounced for the firms with high IO. This supports the argument that intensive arbitrage trading conducted by

informed institutional investors, in contrast to individual investors after the introduction of equity index futuresmotivates

them to closely monitorunderlying firms. Such enhanced monitoring facilitates the disseminationof bad news into equity

price and results in a lower likelihood of future price crashes. Next, we control for IO and document the significant

negative impact of equity index futures trading on future stock price crash risk, which might be due to the enhanced

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We check the robustness of our results using stocks that are included in the CSI300 index for at least 1 year and find consistent results.