Index futures trading and spot volatility in China: A semiparametric approach with range‐based proxies

• Author: Yulei Peng,Na Tan,Zhewen Pan,Yanchu Liu
• DOI: http://doi.org/10.1002/fut.21858
• Date: 01 October 2017
• Published date: 01 October 2017

Received: 1 March 2017

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Accepted: 31 March 2017

DOI: 10.1002/fut.21858

RESEARCH ARTICLE

Index futures trading and spot volatility in China:

A semiparametric approach with range-based proxies

Na Tan

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Yulei Peng

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Yanchu Liu

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Zhewen Pan

Lingnan (University) College, Sun Yat-sen

University, Guangzhou, China

Correspondence

Yulei Peng, Lingnan (University) College,

Sun Yat-sen University, Guangzhou

510275, China.

Email: pengyulei@gmail.com

Funding information

National Natural Science Foundation of

China, Grant numbers: 71371199,

71503280, 71501196; Natural Science

Foundation of Guangdong Province,

Grant number: 2014A030310478;

Innovative School Project in Higher

Education of Guangdong, Grant number:

GWTP-BS-2014-17; Fundamental Research

Funds for the Central Universities,

Grant numbers: 14wkpy64, 14wkpy63;

Major Program of the National Social

Science Foundation of China,

Grant number: 15ZDA014; Lingnan

(University) College; Advanced Research

Institute of Finance

We relax the linear conditional mean assumption in Hsiao et al. (2012). Journal of

Applied Econometrics, 27(5), 705–740 and extend it to a single-index semi-

parametric setting. The asymptotic distribution properties are derived and the semi-

parametric model is applied to study the treatment effect of introducing the stock

index futures contracts in China. Our empirical results indicate that the introduction

of stock index futures significantly reduced stock market volatility before

October 2014, but the long-run effect is not significant. This temporary stabilization

effect is robust to different underlying spot indexes, to various proxies of volatility,

and to placebo tests on the introduction date of stock index futures.

JEL CLASSIFICATION

C14, C58, G14

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INTRODUCTION

The impact of trading stock index futures on the volatility of spot stock markets still remains controversial, even though index

futures have been introduced since 1982. Supporters believe that the introduction of stock index futures could reduce the stock

market volatility by offering stock price discovery, providing market participants with risk-management toolkits, and improving

the efficiency of the related spot markets (Bessembinder & Seguin, 1992; Campbell, Lettau, Malkiel, & Xu, 2001; Cox, 1976;

McKenzie et al., 2001; Ross, 1977). However, opponents argue that the high leverage inherent in futures trading causes

excessive speculation in spot stock markets. They assert that this makes stock prices more volatile due to cross-market arbitrage

behavior, especially when markets fall during a financial crisis (Baldauf & Santoni, 1991; Harris, 1989; Kamara et al., 1992; Lee

& Ohk, 1992; Pericli & Koutmos, 1997).

This controversy has contributed to a substantial amount of literature that empirically examines the impact of futures trading.

Most of this literature uses a dummy-variable approach when examining the effect on spot market volatility of trading stock

index futures. This approach provides a time-series comparison of the estimated volatilities before and after the introduction of

index futures. However, this approach may omit some latent factors, which leads to a biased estimation of the impact of futures

trading.

J Futures Markets. 2017;37:1003–1030. wileyonlinelibrary.com/journal/fut © 2017 Wiley Periodicals, Inc.

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This study differs from these previous approaches in that we develop a semi-parametric panel data policy evaluation

approach to construct the counterfactuals, and we apply this method to study the treatment effect of index futures on the spot

volatility in China. Our approach stems from Hsiao et al. (2012) and is closely related to Ouyang and Peng (2015). However, we

significantly relax the key linear conditional mean assumption of Hsiao et al. and propose a single-index semi-parametric setting,

which is substantially more robust and can effectively avoid the possible curse of the dimensionality problem, compared with

that of Ouyang and Peng.

As China’s stock market has been growing so fast since 1992, its financial markets have been playing increasingly important

roles in global financial markets. The Chinese stock market differs from more well-developed markets, such as those in the

United States, the United Kingdom, and Germany, in terms of its own unique characteristics, such as investor composition and

trading mechanisms. Retail investors other than institutional investors account for the major portion of trading volume, making

for more volatile prices. Even though its market’s short-selling mechanism is a recent introduction, the Chinese stock market is

still not very popular among participants because of its high transaction costs and lack of lenders, which may cause high

fluctuations in stock price. On April 16, 2010, in order to further develop the Chinese financial market, the China Financial

Futures Exchange formally introduced CSI 300 index futures contracts. This is a significant step that allows an assessment of the

impact of introducing the stock index futures on China’s stock market volatility.

Another important issue is the way to measure the spot market volatility. Most existing empirical studies measure volatility

by using the standard deviation of the daily returns of the CSI 300 index, which is commonly used as a representative index to

measure the Chinese stock market’s overall performance. However, there is a consensus in the financial econometrics literature,

which states that, under the same sampling frequency, range-based estimates of volatility are more efficient than the

corresponding standard deviation estimates. This is because range-based estimates are more robust than estimates of close-to-

close returns are. That is, by the non-parametric feature of its definition, a range-based estimate reflects the informative

fluctuations that occur within the sampling intervals. This property makes range-based estimators perfectly suitable to measure

the volatility of Chinese markets, which are largely dominated by retail investors and, hence, are typically associated with

excessive speculative trading and high price fluctuations (see, e.g., Ng & Wu, 2007; Yang et al., 2012). In this paper, we examine

whether the effects of stock index futures trading would be consistent for different volatility proxies other than only using the

conventional means of measuring volatility by standard deviation. Instead of the CSI 300 index, we also measure price-

fluctuation volatility based on the non-overlapping CSI 500 index, whose constituents are entirely medium and small-cap stocks.

Moreover, Xie and Mo (2014) and Xie and Huang (2014) argue that the conclusion of Chen, Han, Li, and Wu (2013) suffers

from a critical issue that the sample period in the latter is too short to detect the possible long-term effects of index futures on the

spot market. Our study examines this issue by extending the sample period up to February 2016, which is more than 4 years after

the commencement of the index futures trading.

To sum up, we develop a semi-parametric panel data policy evaluation approach to estimate the treatment effect and derive

the asymptotic distribution properties. We use the daily high-low ranges to obtain the monthly volatility, other than the standard

deviation of the daily returns. We apply this approach to estimate the impact of trading stock index futures on the volatility of spot

stock markets in China. Our empirical results show that the introduction of index futures significantly reduced the volatility of

stock markets in China before October 2014. However, when we extend the time interval to February 2016, this effect is no

longer significant. This temporary stabilization effect of CSI 300 index futures not only exists in its underlying spot index, that is,

the large-cap CSI 300 index, but also in the non-overlapping CSI 500 index. Our findings are robust to various proxies of

volatility, including the emerging range-based estimators, the conventional standard deviation estimators, and the placebo tests

on the introduction date of the stock index futures contracts.

The rest of the paper proceeds as follows: section 2 offers a brief literature review. Section 3 presents the model setup,

extends the model to a semi-parametric setting, and states the related asymptotic theorems. Section 4 describes the data. Sections

5 and 6 provide our empirical results and robustness checks. We conclude in section 7.

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LITERATURE REVIEW

Stock index futures were first introduced in 1982. A large number of empirical studies investigate the impact of the introduction

of stock index futures trading on the volatility of the underlying stock spot market in markets across different countries.

However, the results yield conflicting evidence in both mature and emerging markets.

For mature markets, Antoniou et al. (2005) provide evidence to support the idea that futures markets help stabilize spot

markets. Their findings could be interpreted to mean that the introduction of futures trading eliminates the impact of noise trading

and aids in the formation of equilibrium in market fundamentals in the spot markets of six countries, including Germany, Japan,

Spain, Switzerland, the United Kingdom, and the United States. In addition, for the Italian market, Bologna and Cavallo (2002)

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TAN ET AL.