Noise Trading and Single Stock Futures: Modifying Sentana & Wadhwani’s Model

Abstract

Derivatives, and their influence on the dynamics of underlying stock markets, is an interesting topic of debate, which predates their introduction. The unresolved influence of derivatives on their underlying stock markets still intrigues many. In this regard, researchers/stakeholders are still curious about the (de)stabilizing influence of derivatives on the overall market. In disposition of these observations, two contradicting hypothesis have been studied widely and have remained the focus of attention in several theoretical and empirical studies. These hypotheses are explained in several ways. Among many, one explanation refers to the destabilizing influence of derivatives, due to the enhanced involvement of noise traders, after the introduction of derivatives. This aspect remains the topic of discussion for this study. After the formal introduction of the SSFs (Single Stock Futures) in Pakistan, this topic became a cause of concern for the stakeholders of this market as well. Hence, this study attempts to tap into this aspect of the de(stabilization) debate, by proposing a modified version of the famous Sentana & Wadhwani (1982) model. In order to tap the potential shortcomings of the S&W model, this study contributes to the extant literature in several ways: 1) It adds the feature of trading volume in the model to analyze and study the potential movement of noise traders from spot to futures market, due to the ease of trading that the futures markets offer, 2) the new, modified model adds a lagged term for returns in order to tap the potential asynchronous inefficiencies, 3) it considers the Generalized Error Distribution (GED) instead of the Gaussian Distribution, in order to realize the fact that returns are not normally distributed. Generally speaking, the modified version of the model not only extends the original model in terms of its explanation, but also empirically tests this aspect in the Single Stock Futures (SSFs) market of Pakistan. This model tested whether SSFs promote, or inhibit the noise trading post-SSFs. After putting it to test, the newer model did not report any negative or positive impact of the introduction of SSFs on the underlying stocks. This may conclude that the proclaimed (de)stabilizing role of the SSFs, in the context of Pakistan, is not justified. This may also imply that the stringent regulatory frameworks, post the Global Financial Crisis, (GFC) for the resumed SSFs, are not justified and require revision.