Market quality of India's financial markets: a case study in equities and single stock futures of the National Stock Exchange
According to the World Bank, India is the world's 5th largest economy and correspondingly has a very large capital market. It has two major stock markets being the Bombay Stock Exchange (BSE), the tenth largest in the world and the National Stock Exchange of India (NSE), the eleventh largest measured by turnover. However, more importantly, India has the second largest single stock futures (SSF) market by turnover globally. These sophisticated derivative products have existed since 2001 and have seen significant uptake in India due to the similarity with the badla system - a leveraged equity investment facility. The connection between the derivatives and equity markets of India facilitated by the preponderance of single stock futures, provides an opportunity to investigate a number of questions relating to the operation of integrated financial markets which address gaps in the literature relevant to academia, industry, regulators and participants alike. Broadly, these questions are: how trading frictions impede information dissemination mechanisms across markets; the relationship between market fairness and efficiency, revealed when markets undergo a change in integration of arbitrage-linked securities; and the impact of certain market participants on short-run efficiency and information provision.
The first set of empirical tests presented analyses how trading protocols impede the price discovery process in single stock futures. Trading protocols can be as simple as opening times to as complex as what the preferential treatment certain order types receive in an electronic orderbook. Investments in equity markets and single stock futures are highly substitutable, which provides data to measure the contribution of each to price discovery. This study reports that the futures market accounts for only 35% of the total price discovery despite its trade volume dominance, and its trade and leverage cost efficiency. The futures market's informational efficiency is adversely affected by market frictions in the form of market-wide position limits, minimum contract values, and margin requirements. A conclusion is that the trading protocols of the single stock futures market impact upon the information dissemination process across the integrated markets. The implication of this is that the full benefits of the derivatives market in India may not be being realised and the design features of this market could be modified to enhance its efficiency.
The second set of empirical tests examines the fairness and efficiency across integrated markets. The impact of derivatives is almost invariably measured by the liquidity outcomes in the spot, ignoring market fairness considerations. This dissertation provides evidence that the presence of a derivative improves the liquidity of the underlying but decreases the degree of fairness - proxied by manipulation likelihood. This analysis shows that a leveraged derivative entices manipulation of the underlying securities and shows that typical inhibitors of manipulation, such as high visible execution costs, are beneficial to successful manipulation.
The final set of empirical tests examines the short-run weak-form efficiency of stocks. This study uses a proprietary data set permitting analysis of orderbook characteristics to measure short-term price predictability within the spot securities. The results show that high levels of algorithmic trader activity in a stock lowers the level of short-run predictability. The analysis also shows that within algorithmic traders, proprietary algorithms provide most pricing information.
