Derivatives Trading and Stock Market Volatility: A Systematic Review

Abstract

Derivative products like futures and options on Indian stock markets have become important instruments of price discovery, portfolio diversification and risk hedging in recent times. Two contractictory views exist relating to the impact of derivatives on spot market volatility. The first view is based on the theory of destabilizing forces, which assumes that derivatives trading leads to an increased stock market volatility due to the high degree of leverage involved. The second view is based on the theory of market completion which suggests that derivatives help in improving market depth, liquidity, market efficiency price discovery, reduce asymmetric information and reduces the volatility of the cash market. The present paper aims at presenting a comprehensive review of literature related to the introduction of derivatives and their impact on spot market volatility.