Volatility and derivatives turnover: a tenuous relationship

Serge Jeanneau and Marian Micu

BIS Quarterly Review, 2003

Abstract: It is often presumed that higher market volatility begets more active trading in derivatives markets. A number of empirical studies have confirmed that such a positive relationship between volatility and activity exists. However, those studies have usually drawn on analyses that apply mainly to daily or intraday data. Very few studies have considered the existence of a possible relationship between volatility and volume from one month to the next. Moreover, the nature of the trading that could give rise to such a relationship is generally left unexplained. In this special feature, we examine the relationship between volatility and monthly activity in exchange-traded derivatives contracts. First, we discuss the various trading motives that would lead to such a relationship. We distinguish between hedging motives and information-based motives. Moreover, we distinguish between motives that tend to generate a relationship between volatility and volume on a day-to-day basis from those that would create a relationship on a month-to-month basis. We then examine the issue empirically. We look at two different markets, that for S&P 500 stock index contracts and that for 10-year US Treasury note contracts. We further look at two types of contract for each market, futures and options, and two measures of activity, turnover and open interest. We also use two conceptually distinct measures of market uncertainty, namely actual (or historical) and implied volatility. Our results generally show a tenuous relationship between volatility and monthly activity in our selected contracts. More specifically, there is no statistically significant relationship between volatility and turnover in 10-year US Treasury note futures and options contracts. However, there does seem to be a negative relationship between volatility and turnover in S&P 500 stock index contracts. Such results stand in contrast to much of the earlier literature on the relationship between financial market volatility and activity. We suggest an interpretation of these results.

Date: 2003
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