Annual Progress Report

on
Post Doctoral Fellowship
Abhijeet Chandra (MS12IPF01)
Mentor (& Co-author): Prof. M. Thenmozhi
DoMS, IIT Madras
(July 2012June 2013)

Introduction
Research-in-progress:
Investor sentiment index and stock market
returns
India VIX and risk management
Liquidity in currency options market in India

Visible Output:
Investor sentiment index: 5th Meeting of AoBF&E
India VIX: Communicated as NSE Working Paper
Liquidity in currency options: IICM Working
Paper

Future plan:
Revisions

Investor Sentiment Index

and Stock Market
Returns
Accepted for presentation at the 5th Annual Meeting of the
Academy of Behavioral Finance & Economics
DePaul University, Chicago, IL, USA
September 17-20, 2013

Motivation
Theorists challenging the underlying assumptions of CAPM,
EMH and other finance theories (Slovic et al., 1977; Kahneman
& Tversky, 1979; Thaler et al., 1985):

Rational expectations, of economic agents,

Ability to quickly processing of information,

Every market participant is correct on the average.

Investor sentiment affects aggregate financing patterns of

investors (Shiller, 2000; Henderson et al., 2006; Kim &
Weisbach, 2008).
Sentiment of market participants drives prices to abnormal
levels (Baker and Wurgler, 2007; Baker, Wurgler & Yuan,
2012).

Research Objectives
Relationship between aggregate investor sentiment
and stock market returns:
Create a quantitative measure of aggregate investor
sentiment for Indian market;
Correlation
measure

between

and

stock

aggregate
market

in

investor
the

form

sentiment
of

return

predictability;
Effect of total investor sentiment on Indian stock market;
and
Causality between sentiment measure and market returns.

Data and Variables

Market-related implicit proxies for investor sentiment:

Turnover-volatility multiple (TVM),

Ratio of imbalances between total buy volume to total sale volume

(IBS),

Ratio of trading volume of put options to that of call options (PCR),

No. of IPOs (NIPO), and

Dividend premium (DP)

Stock market returns: NSE Nifty index logarithmic returns

Data frequency: Monthly (156 obs.)
Period: Jan-2000 to Dec.2012

Sentiment Index: Construction

Aggregate sentiment index:

First principal component of orthogonalized five MRIPs; explains

48% of the sample variance.

TotSenttt = 0.301*TVRt + 0.045*IBSt 0.209*PCRt + 0.345*NIPOt

0.0688*DPt

To filter out the idiosyncratic noise, aggregate sentiment

index is decomposed into:

Rational component using five macro series (Industrial Production

Growth, Inflation, Term Premium, Short-term Interest Rate, &
Exchange Rate), and

Irrational component (Senttt): residuals of first-step regression of

the above fundamental factors and aggregate sentiment measure.

Sentiment Index: Properties

Descriptive Statistics
Mean

SD

Min

Max

TVM

0.072

0.031

0.011

0.203

IBS

0.006

0.057

-0.320

0.241

PCR

0.296

0.137

0.098

0.589

NIPO

3.985

1.624

0.000

18.00

DP

-0.067

0.342

-3.091

2.014

Sentt

0.084

6.328

13.24

34.68

8.041

0.012
1

Ret

Nifty

6.831

8.976

TVM
1.00
(.)
0.231
(0.094
)
-0.098
(0.271
)
-0.395
(0.000
)
0.268
(0.072
)
0.682
(0.00
0)
0.451
(0.082
)

IBS

Correlation
(p-value)
PCR
NIPO
DP

Sentt

Nifty

1.00
(.)
-0.072
(0.125
)
-0.108
(0.118
)
0.628
(0.032
)
0.142
(0.32
7)
0.104
(0.429
)

1.00
(.)
-0.286
1.00
(0.032
(.)
)
-0.019 -0.197
1.00
(0.231 (0.103
(.)
)
)
0.126 0.037 0.197
1.00
(0.30 (0.12 (0.09
(.)
1)
8)
8)
0.331 0.521 0.329 0.634
(0.004 (0.003 (0.042 (0.008
)
)
)
)

1.00
(.)

Sentiment Index and Market

Returns
.10
Market Returns
InvestorSentiment Index

40

.06

30

.04

20

.02

10

.00

-.02

-10

-.04

-20

-.06

-30

-.08
Jan 00

-40
Jan 02

Jan 04

Jan 06

Jan 08

(Period: Jan. 2000 - Dec. 2012)

Jan 10

Jan 12

Investor Sentiment Index

Market Returns

.08

50

Sentiment Index and Market

Returns
Constant

Sentt (t-1)

RetNifty(t-1)

Model 1

Model 2

-0.1925
(0.1301)
[0.3185]
-0.1987
(0.0259)
[0.0000]

-0.0132
(0.0001)
[0.0083]
-0.3234
(0.0188)
[0.0000]
-0.02485
(0.0193)
[0.0810]

R2

0.3561

0.4124

Adj. R2

0.3554

0.3087

F-stat

79.4278

83.9810

Sentt is the total investor sentiment and RetNifty is the Nifty returns.
Standard error and pvalue are reported in ( ) and [ ], respectively.
Model 1: RetNifty = 0 + 1*Sentt(t-1) +
Model 2: RetNifty = 0 + 1*Sentt(t-1) + RetNifty (t-1) +

Summary
Construction of composite investor sentiment measure from
MRIPs and decompose it into rational and irrational sentiment
components;
Statistically significant negative relationship between past
level of investor sentiment and present stock market returns;
Our measure of investor sentiment serves as a strong
contrarian predictor of future stock market returns;
More significant predictor than past returns (Verma-Soydemir,
2009);

Irrational and idiosyncratic sentiment of market participants

causes and determines movements in stock prices (Baker and

India Volatility Index and

Risk Management
Based on the work carried out under National Stock Exchange
Commissioned Research Initiative
Communicated as NSE Working Paper
Forthcoming

India Volatility Index (India

VIX)
Introduced by National Stock Exchange of India Ltd.
in April 2008
Measures market expectations of near-term volatility
In terms of the rate and magnitude of changes in prices

A proxy for risk widely recognized in academia and

industry
Diagonally opposite
movements of7,000India VIX and Nifty
India VIX
Nifty Index
6,000
Index
4,000

60

3,000

50

2,000

40
30
20
10
100

200

300

400

500

Period

600

700

800

900

Nifty Index

India VIX

5,000

Research Questions
Is India VIX
risk?

a true indicator of market

Does it capture risk

compared
to
other
measures?

more accurately,
traditional
risk

Does India VIX indicate investor sentiment?

How is India VIX related to market returns?
How do we use India VIX for trading?

Data Variables and Methods

Data period: 1-Mar-2009 to 30-Nov-2012
Daily closing prices of Nifty Index spot and
futures, India VIX, and Low Volatility Index (LVX).
Data source: National Stock Exchange of India Ltd.
Datazone
Methodology
Multiple regression framework
Finite sample performance criteria: Root mean
square error (RMSE), Mean absolute error (MAE),
Mean absolute percentage error (MAPE)
Quantile regression approach
Computed volatility estimates:
Std. Dev., GARCH(1,1), EGARCH(1,), Realized
Volatility, and Ex-post Volatility

India VIX as Risk Measure:

Theoretical Background
Implied volatility index efficient in
reflecting historical volatility
Flemming (1998), Jiang & Tian (2005), Dowling &
Muthuswamy (2005)

Limited efficiency of implied volatility

index
in
estimating
historical
volatility
Becker et al. (2006), Frijns et al. (2008), Becker et
al. (2009)

Even if biased, implied volatility index

does a better job than any historical
volatility measures

India VIX as Risk Measure:

Performance
(A)Independent variable: India VIX (in percentage
terms)
Dependent
variable
Std. dev. of
Nifty returns
(STDEV)
Daily variance
estimator
(RVOL1)
Realized
volatility
(RVOL2)

Constant

-0.002241
(0.000398)
[-5.627820]
-0.000360
(2.11E-05)
[-17.10039]
-0.007205
(0.000421)
[-17.10039]

0.059930
(0.001534)
[39.05863]***
0.002245
(8.12E-05)
[27.64348]***
0.044891
(0.001624)
[27.64348]***

Adj. R-square

F-Statistic

0.625191

1525.576

0.455032

764.1617

0.455032

764.1617

(B) Independent variable: Return on GARCH

volatility estimates
Std. dev. of
Nifty returns
(STDEV)
Daily variance
estimator
(RVOL1)
Realized
volatility
(RVOL2)
Standard errors and

0.012610
0.004906
0.002391
(0.000194)
(0.002747)
[64.98644]
[1.786133]*
0.000196
0.000230
0.002867
(8.51E-06)
(0.000121)
[23.02321]
[1.904725]**
0.003920
0.004591
0.002867
(0.000170)
(0.002410)
[23.02321]
[1.904725]**
t-statistics are reported in ( ) and [ ] respectively.

3.190272

3.627976

3.627976

India VIX as Risk Measure: Performance

(C) Independent variable: Return on EGARCH
volatility estimates
Dependent
variable

Std. dev. of
Nifty returns
(STDEV)
Daily
variance
estimator
(RVOL1)
Realized
volatility
(RVOL2)

Adj. R-square

F-Statistic

0.002424
(0.002938)
[0.825161]

-0.000349

0.680891

0.000196
(8.53E-06)
[22.93766]

5.92E-05
(0.000129)
[0.459236]

-0.000864

0.210898

0.003914
(0.000171)
[22.93766]

0.001184
(0.002579)
[0.459236]

-0.000864

0.210898

Constant

0.012606
(0.000194)
[64.86276]

(D) Independent variable: Ex post volatility

estimates
Std. dev. of
Nifty returns
(STDEV)
Daily variance
estimator
(RVOL1)
Realized
volatility
(RVOL2)

0.010466
(0.000256)
[40.96350]
0.000113
(1.14E-05)
[9.916760]
0.002262
(0.000228)
[9.916760]

0.052056
(0.004401)
[11.82765]***
0.002012
(0.000196)
[10.23976]***
0.040232
(0.003929)
[10.23976]***

0.131916

139.8933

0.102031

104.8527

0.102031

104.8527

India VIX as Risk Measure:

Performance
(A)Root Mean Square Error (RMSE)
Std. dev. of
Nifty returns
(STDEV)
Daily variance
estimator(RVO
L1)
Realized
volatility
(RVOL2)

India VIX (%)

GARCH
volatility
estimates

EGARCH
volatility
estimates

Ex post
volatility

0.003592

0.005861

0.005869

0.005467

0.000190

0.000257

0.000258

0.000244

0.003802

0.005143

0.005152

0.004880

(B) Mean Absolute Error (MAE)

Std. dev. of
Nifty returns
(STDEV)
Daily variance
estimator(RVO
L1)
Realized
volatility
(RVOL2)

0.002294

0.003901

0.003903

0.003557

9.00E-05

0.000131

0.000131

0.000119

0.001801

0.002614

0.002615

0.002378

(C) Mean Absolute Percent Error (MAPE)

Std. dev. of
Nifty returns
(STDEV)

17.72460

32.48665

32.51716

29.2306

India VIX as Risk Measure: Summary

IVIX explains realized volatility in all three cases and results
are statistically significant.
GARCH volatility estimate also explains realized volatility but
results are not as statistically significant as in case of IVIX;
EGARCH volatility estimate yields statistically insignificant
results, hence not capable to capture realized volatility.
Ex-post volatility also captures realized volatility with
statistically significant results, but the explanatory power of
this measure vis--vis IVIX is very low (low R-square values).
Using performance criteria such as RMSE, MAE, and MAPE
supports the above findings:

India VIX emerges as the best estimate of realized volatility compared

to measures from ARCH/GARCH family and ex-post volatility
measures;

India VIX explains realized volatility irrespective of measures used to

compute the same.

India VIX and Stock Returns:

Background
As market volatility rises, investors demand higher
expected returns and prices go up!
Inverse relationship between volatility and returns
Flemming et al. (1995), Dash & Moran (2005),
Kumar (2012), Sarwar (2012)
Volatility index as a barometer of investors downside
fear than that of their excitement
Whaley (2009), Giot (2005a)
Asymmetric
nature
of
volatility
index-return
relationship
Whaley (2000), Simon (2003), Skiadopoulos (2004),
Ting (2007), Kumar (2012)
Counter evidence: Dowling & Muthuswamy (2005),
Siriopoulos & Fassass (2009)

India VIX and Stock Returns:

Modeling
Our model takes the form of multiple
regression as follows:
IVIXt = 0 + 1*IVIXt-1 + 2*NiftyRet+ +
3*NiftyRet- + 4*DevMA5+ + 5*DevMA5+
where,
IVIXt is first difference of the IVIX at time t,
IVIXt-1 is the lagged value of change in India VIX,
NiftyRet+ and NiftyRet- are positive and negative
Nifty returns for same day, and
DevMA5+ and DevMA5- are positive and negative
percentage deviations of the closing Nifty from its
five-day moving average.

India VIX and Stock Returns: Results

Variable
Constant

Model 1
0.421748
(0.153655)
[2.744781]**

India VIXt1

*
-0.018025

Model 2

Model 3

Model 4

Model 5

Model 6

0.291226

0.300961

0.153416

0.253676

0.085257

(0.146569)

(0.133550)

(0.141911)

(0.133795)

(0.132001)

[1.986960]**

[2.253540]**

[1.081067]

[1.895999]**

[0.645881]

-0.034244

-0.024601

(0.005308)

(0.005305)

[-

[-

6.451712]**

4.637139]**

-0.030570

(0.005845)

-0.002456

(0.005124)

[-

(0.005765)

[-

3.084024]**

[-0.425984]

5.966468]**

-0.010671
(0.005657)
[1.886461]**

Nifty Rett

-48.13079

-32.81898

*
-42.34883

(+)

(4.782851)

(4.882665)

(5.479945)

[-

[-

[-

10.06320]**

6.721530]**

7.727966]**

*
Nifty Rett(-)

DevMA5t
(+)

-95.61711

*
-104.6000

*
-84.47708

(5.468687)

(5.983996)

(7.686176)

[-

[-

[-

17.48447]**

17.47995]**

10.99078]**

0.010245

0.003085

(0.001106)

(0.001398)

[9.261779]**

[2.205922]**

*
DevMA5t (-)

-0.003135

-0.008306

(0.000953)

(0.001137)

India VIX and Stock Returns: Summary

We examine the impact of Nifty on implied volatility w.r.t.
its sign-based historical returns and deviations from central
tendency:
Change in India VIX is regressed upon its own lagged value,
+ve and -ve returns on Nifty, and +ve and -ve % deviation of
Nifty from its 5DMA.

Nifty returns exhibit significant directional impact on India

VIX:
Higher +ve returns Greater declines in India VIX, and
Higher ve retunrs Greater increases in India VIX.

Any positive returns by themselves reduces fear in market

and changes investor sentiment to positive node.
Downward trend of stock prices reinforces the effect of
negative returns and IVIX rises even more.
Results obtained by using quantile regression approach and
by replacing India VIX with LVX provide similar results and
support our findings thus far.

India VIX and Market Timing:

Background
Capital market equilibrium and investors risk-aversion
allows MRP to be positively related to market portfolio
variance (Merton, 1987) and also to expected volatility
(French et al., 1987)
Any unexpected +ve change
unexpected ve stock returns.

in

volatility

leads

to

This argument used to design trading strategies based on

volatility index movements.

Copeland & Copeland (1999)

Market timing strategies based on portfolio size (small-cap
vs. large-cap) and portfolio style (value and growth)

Bagchi (2012)
Positive and significant relationship between India VIX and
value-weighted portfolios based on beta, market-to-book
value, and m-cap

India VIX and Market Timing:

Methods
Portfolio proxies:
CNX Nifty index futures as a proxy for large-cap portfolio, and
Nifty Midcap 50 index as a proxy for mid-cap portfolio.

Difference in returns on Nifty futures index and the

Nifty midcap futures index on the percentage change in
India VIX:
(RNifty, t RMidcap, t )= + *IVIXt + t
where,
RNifty, t is returns on the Nifty futures index at time t,
RMidcap, t is returns on the Nifty Midcap futures index at time t,
and
IVIX is the change in India VIX.

Market Timing with India VIX: Results

Holding
period
(in days)

%-age
change in
IVIX

Number of
days*

Cumulative
returns

Daily
average
returns

1
1
1
1
1
1
1

10
20
30
40
50
-10
-20

70
27
16
14
1
158
77

-0.14556
0.09503
0.05474
0.02636
0.01595
0.12651
0.06397

-0.00211
0.00336
0.00526
0.00564
0.00485
0.00154
0.00378

2
2
2
2
2
2
2

10
20
30
40
50
-10
-20

83
33
22
18
2
186
99

0.11856
0.10271
0.04823
0.02705
0.01831
0.07491
0.04711

0.00148
0.00294
0.00331
0.00442
0.00452
0.00079
0.00219

3
3
3
3
3
3
3

10
20
30
40
50
-10
-20

93
38
27
22
2
205
117

0.09503
0.10976
0.06435
0.01739
0.01153
0.08783
0.05416

0.00108
0.00271
0.00355
0.00237
0.00245
0.00083
0.00212

10
10
10
10
10
10
10

10
20
30
40
50
-10
-20

137
61
54
38
3
288
197

-0.02198
-0.01894
0.03297
0.02118
0.02172
0.04930
0.08001

-0.00017
-0.00031
0.00093
0.00164
0.00224
0.00034
0.00189

* indicates the number of days the portfolio remains in a given position.

Positive percentage change in the India VIX implies long large-cap portfolio, and negative percentage change in
the India VIX indicates long mid-cap portfolio.

Market Timing with India VIX:

Results
We switch from mid-cap to large-cap portfolio when India
VIX increases, and vice versa.
Tested for different holding periods, i.e. 1, 2, 3, and 10 days;
Also, different percentage changes in India VIX levels taken as
signal to switch portfolios.

Switching to large-cap portfolio based on India VIX

changes results in +ve cumulative returns in 17/20 cases.
Switching portfolios based on lower (10%) change in India VIX
gives negative returns in two cases.
Using higher percentage change in India VIX as signal to switch
portfolio appears a useful strategy to maintain +ve portfolio
returns.

Summary
IVIX a better predictor of realized volatility than
traditional conditional models.
Significant negative relation between IVIX and
Nifty returns.
Two indices move independently in case of
higher upward movements;
Not so significant relationship for higher
quantiles in case of negative movements
Strong candidate for risk management and
portfolio insurance
Higher percentage change in IVIX acts as a signal
to switch between large- and mid-cap portfolios This portfolio size-based strategy ensures positive
returns.
India VIX can be useful for traders and investors

Liquidity in Currency
Options Market in India
Presented at the XIth Capital Markets Conference 2012
Indian Institute of Capital Markets, Navi Mumbai
December 2012
IICM-SSRN Working Paper: http://ssrn.com/abstract=2255475

Liquidity
Signals the feasibility for a trader to buy or sell a
security for a fair price;
Provides opportunity to move in and out of
positions without any noticeable premiums or
discounts on fair market prices.
irrespective of trade size

Trading of options on USD-INR currency pair

introduced by NSE in Oct. 2010.
Currency options trading at NSE generates
highest trading volume in the world (WFE, 2011).
139,296 contracts worth Rs.636.78 cr. as on Dec. 2010;
11,103,261 contracts worth Rs 6,057.03 cr. as on Sep.
2012.
31

Theoretical background
Liquidity-as-sentiment theory (Baker
& Stein, 2004):
Rational investors under-react to the info
contained in trade order flows, thereby
boosting liquidity;
Market is dominated by irrational
investors, and hence overvalued;
High liquidity signals a positive sentiment
of irrational investors, leading to low
expected returns.

32

Theoretical background
cont
Liquidity and Volatility
Inventory models of liquidity:
Negative relationship between liquidity and
volatility (Stoll, 1978; Amihud & Mendelson, 1980;
Copeland and Galai, 1983)

Information-based models of liquidity (mixed

relationship):
Informed trading amidst a larger group of
uninformed traders leads to a positive relationship
between volatility and liquidity (Admati &
Pfleiderer, 1988; Barclay & Warner, 1993)
Specialist knowledge of the presence of informed
traders results in a negative relationship between
volatility and liquidity (Foster & Vishwanathan,
33
1990; Pastor & Stambaugh, 2003)

Theoretical background
cont
Ambiguous information gives rise to
illiquidity in the market where riskneutral arbitrageurs chose not to trade
in a rational equilibrium (Ozsoylev &
Werner, 2011).
Virtually, no study on
currency options market;

liquidity

in

We attempt to study the issue of

liquidity and its relationship with other
factors in the currency market in India.
34

Contributions
Validates
the
behavioral
theories of liquidity:

finance-based

Liquidity-as-sentiment theory (Baker & Stein, 2004),

Liquidity
under
rational
equilibrium
theory
(Ozsoylev & Werner, 2011)

Adopts a contemporary approach to examine

the issue of liquidity in currency options
market:
Liquidity measurement in a time-series framework,
Fresh evidences from an emerging market,

Examines the
liquidity
with
speculation.

dynamic
returns,

relationship of
volatility,
and

35

Research Objectives
How is liquidity (or lack of it) in the
Indian currency options market
related to exchange rate returns?
Whether it influences (or
influenced
by)
exchange
volatility?

gets
rate

Whether speculators capital drive

the liquidity in currency options
market?
36

Measures of (il-)liquidity
Some proxy measures of liquidity:
Bid-ask spread (Amihud & Mendelson,
1986; Eleswarapu, 1997; Brennan &
Subrahmanyam, 1996);
Trading volume (in the sense of Black,
1971);
Open interest (Pan & Poteshman, 2006)

Our study uses Amihud (2002) measure

of illiquidity as follows:
Pt 1 change per
The daily
ratio of Average
absolute
ILLIQUID
{ Pt price
}
R
Vol
t
Rupee of daily trading volume:
t

37

Data and Measurement

Variables
Data variables:
Illiquid: Market-level illiquidity in USD-INR
currency options market, following Amihud (2002),
ExReturn: Spot USD-INR exchange rate return,
ExVol:
Exchange
rate
volatility
[following
conditional volatility measure GARCH(1,1)],
OptSpec: Speculation in currency options market,
adapted from Campbell et al. (1993).

Sample period: Nov. 2010 Oct. 2012

First 5 months data exhibit abnormal trend; hence removed.
Data used for further analysis: April 2011-Oct. 2012.

Data source: NSE and RBI websites

38

Methodology
Preliminary analysis: Co-integration test:
There
exists
co-integration
between
variables;
implying long-term equilibrium relationship.

Final analysis: dynamic relationship

between variables examined using:
Vector error correction model
estimates,
Impulse Response Functions, and
Variance decomposition analysis.

(VECM)

39

Data Analysis
Data grouped into two sets, to see if
relationships between the variables
change during the recent period:
Entire data: April 2011 Oct. 2012, and
Recent period: Nov. 2011 Oct. 2012.

Data series tested for:

Stationarity using ADF and PP tests,
ACF and PCF
Appropriate lag length: 6
40

Exchange rate, return and

volatility
USDINR Exchange Rate

58
56

Rs./USD

54
52
50
48
46
44
42

50

100

150

Return

200

250

350

Period

.02

.00020

.01

.00016

.00

Exchange Rate Volatility

.00012

-.01

.00008

-.02

-.03

300

.00004

50

100

150

200
Period

250

300

350

.00000

50

100

150

200
Period

250

300

350

41

Illiquidity and trading volume

.008

12

Illiquidity

10

No. of contracts (Mn.)

.004

.000

-.004

-.008

-.012

Trading Volume
Open Interest

8
6
4
2

50

100

150

200
Period

250

300

350

50

100

150

200

250

300

350

Period

42

Descriptive Statistics
Spot USD

OptTVol

ExReturn

ExVol

Illiquidity

OptSpec

Mean

49.28346

917139.7

0.000400

3.37E-05

0.000310

1.085039

Median

49.17750

828563.0

0.000452

2.83E-05

0.000449

1.008025

Maximum

57.21650

3792800.

0.019244

0.000167

0.090914

3.076671

Minimum

43.94850

22661.00

-0.026559

4.55E-06

-0.105120

0.032209

Std. Dev.

4.210975

589338.3

0.005666

2.34E-05

0.012376

0.497921

Skewness

0.273387

1.150509

-0.007690

1.518131

0.085205

0.963986

Kurtosis

1.561099

5.506306

4.580640

6.545268

23.89564

4.185466

ADF test
statistic

20.6989***
#
20.7004***
#
487

5.454908**

20.66095**
*
20.66237**
*
487

-3.97877**

10.64435**
*
24.48080**
*
487

9.568614**
*
13.50272**
*
459

PP test
stat.

9.085177**

4.007201**

Observatio
487
487
ns
***
Significant at 1% level; **Significant at 5% level; *Significant at 10% level.
#The data series is stationary at 1st difference.

Pair-wise Correlation
Illiquidity

ExReturn

ExVol

Illiquidity

1.000000

ExReturn

0.630442***

1.000000

ExVol

0.006241

-0.010613

1.000000

OptSpec

0.056967*

0.013168

-0.21044***

OptSpec

1.000000

Significant at 1% level; **Significant at 5% level; *Significant at 10% level.

Illiquidity is a proxy of illiquidity in currency options market computed as a daily ratio of
absolute price change in spot exchange rate market and trading volume in derivative market;
ExReturn is measured as the log return on daily changes in spot exchange rate of the USDINR currency pair; ExVol refers to the daily exchange rate volatility measured by the
GARCH(1,1) approach; and OptSpec measures the speculation in currency pair market
following Campbell et al. (1993) methodology.
***

Results and Findings

(Entire data)

Illiquidity ExReturn relationship:

VECM (with 6 lags) shows negative relation,
Evidence of turn-of-month effect,
No day-of-week effect found.

Illiquidity ExVol relationship:

Illiquidity does not influence volatility, neither does
volatility to illqidity,
Global volatility, proxied by CBOE VIX, has no effect
on illiquidity in currency options market .

Illiquidity OptSpec relationship:

Speculating activities drive illiquidity in currency
options market (sig. at all 6 lags).
45

Results and Findings

(Recent period)

Negative
bi-directional
causality
between Illiquidity and ExReturn;
Significant at all lags.

No significant causality from ExVol to

Illiquidity; weak reverse causality.
OptSpec tends to influence positively
both Illiquidity (lag=1) and ExVol (all
lags).
Bi-directional
causality
between
ExReturn and ExVol, former causing
later positively, and vice versa.
46

Results and Findings cont

47

Conclusion
Our study theoretically supports Baker & Steins
(2004) liquidity-as-sentiment theory whereby
liquidity and returns are negatively related.
Turn-of-month effect prevails (hypothetically) implying
high illiquidity at turn-of-month when traders are busy
looking at other things.

No significant relationship between liquidity and

exchange rate volatility (may be because other
macro and global factors affects volatility more
than market factors).
Speculating activities in currency options
market tend to drive liquidity in recent period .
This liquidity pressure from speculators resulting in
high illiquidity may further drive prices and volatility
(Ozsoylev & Werner, 2011).
48

Limitations & Future Scope

Our measure of illiquidity follows timeseries approach using market-level
daily data;
Cross-sectional framework using intraday data on
various strike prices for currency options may yield
better results.

Liquidity-as-sentiment
theory
may
further be tested under rational
expectations of traders;
This supposedly contributes to the liquidity-pricereturn relationship literature in the context of
currency options market.
49

Future work
Investor Sentiment Index:
Test the empirical as well as statistical validity of the
Investor Sentiment Index with various proxies and
other indicators of investor sentiment such as
consumer confidence index.
Use this Investor Sentiment Index to derive market
price of risk/any other pricing kernel to be used in
the behavioral asset pricing model.

India VIX:
Use the change in India VIX as a signal to switch
between portfolios, we propose to test this approach
with style-based portfolio such as growth versus
value portfolios.

Liquidity in Currency Options:

Examine whether illiquidity in the market could be

Thanks!

51

India VIX
Descriptive Statistics: Raw Variables
Nifty

LVX

IVIX

Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
Jarque-

5146.340
5232.050
6312.450
2573.150
624.3712
-1.534916
6.723514
906.3077

3683.985
3883.895
4520.700
1661.870
610.9529
-1.388439
4.4535439
392.8145

25.05361
22.96000
56.07000
13.04000
7.940582
1.376948
4.859700
429.7343

23.18010
21.28000
52.65000
13.45000
7.208186
1.253091
4.294683
309.6657

Bera
Probability
Top Decile
Bottom

0.000000
5825.105
4512.375

0.000000
4294.918
2774.084

0.000000
37.194
16.979

0.000000
33.514
15.99

Decile
Observatio

934

934

934

934

ns

CBOE VIX

India VIX
Descriptive Statistics: Return Series
Nifty Return

IVIX Return

LVX Return

Mean

0.000808

-0.001121

0.001041

Median

0.000720

-0.002067

0.001070

Maximum

0.163343

0.208196

0.104831

Minimum

-0.060216

-0.243570

-0.031225

Std. Dev.

0.014037

0.051997

0.009539

Skewness

1.658820

0.222226

1.241408

Kurtosis

22.38263

4.473660

17.71371

Jarque-Bera

15048.80

92.20181

8665.095

Probability

0.000000

0.000000

0.000000

934

934

934

Observations

India VIX
Correlation: Raw Variables
IVIX

Nifty

CBOE VIX

IVIX

1.000000

Nifty

-0.811718***

1.000000

CBOE VIX

0.677311***

-0.697315***

1.000000

LVX

-0.866983***

0.930436***

-0.619206***

*** significant at 1% level; * significant at 10% level

Correlation: Return Series

IVIX Return

Nifty Return

IVIX Return

1.00000

Nifty Return

-0.494539***

1.00000

LVX Return

-0.488565***

0.919125***

*** significant at 1% level

LVX Return

1.00000

LVX

1.000000

India VIX
Descriptive Statistics: Volatility
Measures
Daily
Standard

Variance

Deviation

Estimator
(RVOL1)

Realized

Ex-post

Volatility

Volatility

(RVOL2)

Measure

Mean

0.012600

0.000196

0.003911

0.155179

Median

0.011064

0.000126

0.002520

0.119212

Maximum

0.042760

0.001846

0.036921

2.592992

Minimum

0.005034

2.47E-05

0.000494

0.0001481

Std. Dev.

0.005874

0.000258

0.005156

0.154338

Skewness

2.657413

4.715300

4.715300

5.213915

Kurtosis

12.77695

27.81013

27.81013

68.73642

Jarque-Bera

4721.253

26858.25

26858.25

165523.9

Probability

0.000000

0.000000

0.000000

0.000000

915

915

915

915

Observations

India VIX
Descriptive Statistics: Conditional
Volatility Estimates
GARCH(1,1) Volatility

EGARCH(1,1)
Volatility

Mean

0.043845

0.045705

Median

0.059965

0.058477

Maximum

7.557753

7.663823

Minimum

-3.109903

-2.964650

Std. Dev.

1.003092

1.004331

Skewness

0.446417

0.478095

Kurtosis

6.374373

6.511658

Jarque-Bera

474.1430

515.4981

Probability

0.000000

0.000000

934

934

Observations

India VIX as Risk Measure:

Correlation between volatility measures
Std.
Dev.

RVOL1

Std.
Dev.

1.00000

RVOL1

0.948971
***

1.00000

RVOL2

0.926482
***

0.984672
***

RVOL2

EGARC
Ex post GARCH
H
Volatilit Volatilit
Volatilit
y
y
y
Measur Estimat
Estimat
e
e
e

1.00000

Ex post
0.363974
0.319085** 0.301089**
Volatilit **
y

1.00000

GARCH
0.922315 0.923289** 0.956223**
0.236389**
Volatilit ***
*
*
y
EGARC
H

0.893097

0.779721** 0.792348**

1.00000

0.893625**

India VIX and Returns:

Quantile Regression Results
Constant
Quantile
0.100

Coefficie
nt
-0.040789

Std.
Error
0.004830

0.200

-0.029041

0.002741

0.300

-0.020870

0.002360

0.400

-0.013467

0.002359

0.500

-0.008562

0.002322

0.600

-0.002679

0.700

Nifty Ret (+)

Coefficie
nt
-2.885320

Std.
Error
0.622635

-2.306564

0.347787

-2.114044

0.247809

-2.000982

0.279463

-1.682696

0.295368

0.002287

tStatistic
8.445208
***
10.59554
***
8.842491
***
5.709776
***
3.687392
***
-1.171526

-1.434995

0.306797

0.003456

0.002593

1.332803

-0.725521

0.800

0.012304

0.002248

5.474460
***

0.900

0.031128

0.003186

9.771529
***

Nifty Ret ()
Coefficie
nt
-1.871360

Std.
Error
0.589094

-2.312653

0.250906

-2.527082

0.304024

-2.875801

0.347046

-3.479595

0.322039

-3.611749

0.274700

0.484944

tStatistic
4.634048
***
6.632114
***
8.530949
***
7.160094
***
5.696958
***
4.677347
***
-1.496091

-3.820224

0.281722

-0.075328

0.083317

-0.904114

-3.890067

0.290346

-0.041410

0.315799

-0.131128

-4.300189

0.453381

*** Significant at 1% level.

Method: Quantile regression (Median); Sparsity method: Kernel (Epanechnikov) using residuals.

tStatistic
3.176677
***
9.217224
***
8.312119
***
8.286503
***
10.80488
***
13.14797
***
13.56028
***
13.39802
***
9.484719
***

India VIX and Returns:

Quantile Regression Summary
Quantile regression estimates used to capture
conditional quantile functions instead of
conditional mean functions (as in OLS).
Provides more robust results in support of earlier
findings.

Negative relationship b/w India VIX and Nifty

index returns in either direction, particularly
around the center of distribution (Q0.5)
Relationship holds more for market declines
than for advances; Effect is sharper for higher
quantiles.
A portfolio with some component of IVIX would

India VIX: Market Timing

Holding period (in

R-square

F-statistics

-0.161193

0.134635

0.032194

23.08576

(0.004484)

(0.028021)

[-35.95108]

[4.804764]***

-0.161603

0.127837

0.029111

20.77905

(0.004490)

(0.028044)

[-35.98797]

[4.558404]***

-0.162012

0.121602

0.026404

18.76685

(0.004496)

(0.028070)

[-36.03410]

[4.332072]***

-0.162373

0.114246

0.023338

16.51196

(0.004506)

(0.028115)

[-36.03569]

[4.063491]***

-0.162741

0.108393

0.021055

14.84029

(0.004512)

(0.028137)

[-36.06922]

[3.852310]***

-0.164102

0.093022

0.015656

10.89484

(0.004535)

(0.028182)

[-36.18846]

[3.300736]***

-0.165538

0.080082

0.011728

8.069915

(0.004548)

(0.028190)

[-36.39563]

[2.840760]**

-0.166754

0.072786

0.009761

6.653317

(0.004561)

(0.028218)

[-36.55864]

[2.579402]*

days)
1

10

15

20

***significant at 1% level, ** significant at 5% level, and *significant at 10% level.