'Expiration day' affectes spot market volatility on stock exchanges: Study

IIM-A sutdy suggests use of arithmetic average price instead of volume-weighted average price

The intraday price volatility on the expiry of derivative contracts are impacted by what is termed as 'expiration day', says an Indian Institute of Management, Ahmedabad (IIM-A) study, authored by faculty members Sobhesh Kumar Agarwalla and Ajay Pandey.

Titled 'Expiration-day Effects and the impact of Short Trading Breaks on Intraday Volatility: Evidence From The Indian Market', the study states, "The spot market volatility dynamics is known to be affected by the 'expiration day effect' on the expiry of derivative contracts. It is known to be caused by the activities of arbitrageurs and speculators and is empirically documented to be affected by the settlement procedure followed in a specific market. In this study, the expiration day effect on the spot price volatility in India was examined using high-frequency trade data."

The study is motivated by two interesting features of Indian market. "First, the cash-settled single-stock futures (SSF) contracts are immensely popular in India unlike most other markets; Second, it uses the volume-weighted average price of a narrow window of trading (last half-an-hour) for the final settlement of derivative contracts. The increased volatility in the last 30 minutes on the expiry day is greater for the SSF stocks, relative to the stocks that are merely part of an index underlying a derivative. Economically, the volatility increase has the effect of reducing the effectiveness of a hedge created by arbitrageurs as they have to unwind their position in the proportion of the volume traded during the relevant period, something that cannot be estimated precisely in advance," the study states.

However, with the current modes of settlement of derivative contracts resulting in significant increase in volume and volatility across exchanges, Agarwalla suggests a rethink over settlement policies.

According to Agarwalla, currently the derivative contracts on individual stocks and indices are cash settled on expiry and the settlement price is determined by the exchanges using closing spot price. The closing spot price, in turn, is defined as the volume-weighted average of the price prevailing during the last half-an-hour of trading in the spot market on the expiration day.

"Empirically, it has been observed that there is a significant increase in the volume and volatility on the expiration days. Whether cash-settled or through delivery of contracts, the current settlement procedures on expiration days result in severe price volatility," says Pandey while commenting on the study. 

However, as one of the two measures, Agarwalla and Pandey suggest taking an arithmetically arrived average price route for settlement of contracts instead of the current method of deciding the closing settlement price based on weighted volume.

"A good policy should make it easy for the arbitrageurs to unwind their positions at a converged price and make it difficult for someone to manipulate the closing price. Alternative procedures used by other markets can be used. For example, a very simple change could be the use of arithmetic average price instead of volume-weighted average price. The arithmetic average can be that of price at the end of each minute of trading during a defined period," says Agarwalla. 

The other remedial measure offered is the use of call auction for determination of settlement price.

"A call auction can be introduced at the close of the market on the expiration days to determine the settlement price. A call auction will ensure that the arbitrageurs are able to unwind the positions at the same price," he further states. 

However, Agarwalla cautions that the call auction may also have to be examined closely as the Indian experience with the call auctions at the market opening has not been so encouraging.