Chapter- 7

Relation Between
Volume, Open
Interest and
Volatility
 CHAPTER-7

Relationship between Volume, Open Interest and

Volatility

7.1 Introduction

The literature has seen a chunk of studies dedicated to explore the

relationship between the volatility of future contract prices and their trading

volume and open interest. A widely documented phenomenon is the positive

contemporaneous correlation between price volatility and trading volume.

Karpoff (1987) reviews previous studies on price volume relation on various

financial markets, in which he cites 18 studies that document the positive

correlation between volatility and volume.

Several theories predict a contemporaneous relation between price

volatility and trading volume. The “Mixture of Distribution” hypothesis

(Clark (1973), Epps and Epps (1976), Tauchen and Pitts (1983), and Harris

(1986)) assumes that the variance per transaction is monotonically related to

the volume of that transaction. Consequently, price changes are sampled

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from a mixture of normal distributions with either the volume per

transaction, number of transactions, or number of information arrivals per

observation unit acting as the mixing variable. Copeland (1976),(1977),

Morse (1981), Jennings, Starks, and Fellingham (1981), and Jennings and

Barry (1983) develop and extend “ Sequential Arrival of Information”

models where new information is disseminated sequentially to traders, and

traders not yet informed can not perfectly infer the presence of informed

trading. Consequently, the sequential arrival of new information to the

market generates both trading volume and price movements, with both

increasing during periods characterized by numerous information shocks.

A third explanation is found in Admati and Pfleiderer (1988), who show

that traders with trade timing discretion choose to trade when recent volume

is large. Therefore, transactions and price movements are bounced in time,

and the effect of volume on price movements depends on recent volume

levels (Admati and Pfleiderer, Hypothesis 3).

As far as futures markets are concerned, open interest is considered to be

another important variable, being used as a proxy for market depth, which

Kyle (1985) defines as the order flow required to move prices by one unit.

His model implies that larger volumes support more informed traders, and

that depth varies with the level of non- informational trading activity.

Further, as noted by Bessembinder and Seguin (1993), a bi-directional

causality relationship between volatility and trading volume (or open

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interest) would support the ‘mixture of distribution’ hypothesis (see Clark

1973). The ‘sequential arrival of information’ theory of Copeland (1976,

1977) would hold if volatility is dependent upon the lagged volume and/or

lagged open interest. Also Admati and Pfleiderer (1988)’s ‘traders with trade

timing discretion tend to trade in heavy liquidity’ theory would apply if

trading volume affects volatility.

Open interest represents the number of future contracts outstanding at any

point in time, where as trading volume captures the number of contracts

traded during a specific time period. Open interest supplements the

information provided by trading volume. Open interest can proxy the

potential for a price change, while trading volume assesses the strength of a

price level. The change in the level of open interest can also measure the

direction of capital flows relative to that contract.

In this chapter, the purpose of the study is to empirically examine the

dynamics of GARCH effect in relation to trading activity variables like

trading volume and open interest in the CNX Nifty Index Futures market.

We have followed the methods developed by Girma and Mougoue (2002) to

investigate, whether by adding the current/ the first lag open interest and

trading volume in the variance equation helps the GARCH model better

explain the volatility in CNX Nifty Index Futures market. Further in contrast

to Girma and Mougoue (2002) we have used the open interest and volume

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series after adjusting for Time to Maturity (TTM) effect which is popularly

known as Samuelson’s Effect (1965).

Most studies of volatility have reiterated the empirical findings that

volatility in financial time series is highly persistent with clearly

demonstrated volatility clustering behavior. See, for example, Mandelbrot

(1963), Bollerslev et al (1994) and Brooks (2002). Numerous models have

been proposed to describe the phenomena of heteroskedasticity and volatility

clustering. Among these models the Autoregressive Conditional

Heteroskedasticity (ARCH) and Generalized Autoregressive Conditional

Heteroskedasticity (GARCH) process developed by Engle (1982) and

Bollerslev (1986) respectively, appear to be appropriate models for the daily

returns of many financial time series. The GARCH (1,1) model is one of the

most successful such parameterization for characterizing high frequency

financial market volatility. One of the common findings in many empirical

applications of this model is a high degree of persistence within the

estimated conditional variance process (see Bollerslev et al. 1992).

The objective of this chapter is to examine the relationship between

volatility, trading volume and/or open interest in an attempt to uncover the

sources of variability in the Nifty Index Future market, in addition to

studying whether volume and/or open interest data help improve the

accuracy of GARCH-type model. A good understanding of the sources of

variability in the Nifty Index Future contract could lead to superior trading

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and hedging strategies. The findings of the study have practical implications

for hedgers such as institutional investors and also individual investors

dealing in equity future market. These findings also could be of interest to

speculators and market regulators fearful of potentially destabilizing excess

volatility in equity futures market.

7.2 Literature Survey

The literature on modeling the relationship amongst volatility, volume and

open interest has seen three main streams of development as discussed in

chapter 2.3.

Taking clues from literature survey (as discussed chapter 2.3), in

this chapter, the study explores the effect of volume and open interest on

Nifty Index Future Return volatility. First, it investigates the effect of

volume and open interest on Nifty Index Future return volatility taken one at

a time. Then, it explores the effect of volume and open interest on nifty index

future return volatility taking both the variables simultaneously in the

conditional variance equation.

7.3 Data and Methodology

The data used are the daily closing prices, trading volume (turnover) of

the contracts, between 12/06/2000 (the date on which future contract on

CNX Nifty Index started trading in NSE) and 29/09/2009 closest to

expiration (i.e. near month contract) for CNX Nifty Future. We have taken

the daily closing prices, volume and open interest of the near month (M)

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future index contract that is deliverable in the same trading month (M). After

the expiration of the (M) month contracts on the last Thursday of that month,

and on the first day of the next trading month (M+l) the data for the contract

which will be deliverable in the month (M+l) is taken. For example, if the

calendar trading month is January, the daily closing prices, volume and open

interest are collected for the contract that is deliverable on the last Thursday

of January. On the day after the closing date of the January, it is rolled over

to February month contract that are deliverable on the last Thursday of

February. The choice of near month contract provides high degrees of

liquidity. In total we have 2324 observations of closing price and trading

volume obtained from nseindia.com the official website NSE (National

Stock Exchange of India). CNX Nifty is a ‘bellwether index’ of NSE

iL

representing 50 stocks across 22 sectors. NSE is the world’s 4 largest

exchange in number of trades in equity as on June’ 09 (source: ISMR). Also

one of the largest equity derivatives volume globally as on Dec’08 (source:

WFERFIA). Nifty represents 52% of the traded volume of NSE (source

NSE) and 63% of market capitalization of NSE (source: NSE; data as of

31.12.2009).

Assuming continuous compounding, the daily return series are calculated

as the first difference of the logarithms of the daily closing prices on future

index contract.

no
 R, = ln(P,/Pa (7.1)

Table: 7.1 presents the various descriptive statistics for the daily Nifty

Future Index return, volume and open interest. The mean daily Index Future

return is 0.000531%, with a standard deviation of 0.018%. The return series

is fat-tailed as reported by excess kurtosis of 11.53 and negatively skewed as

reported by skewness is -0.48. Applying the Jarque-Bera test for normality,

we find strong support for the hypothesis that the time series for future index

returns don’t correspond to a normal distribution. The existing literature

shows that excess kurtosis and skewness are evidence of possible

heteroseedastieity (see, e.g., Akgiray et al., 1991; Hall et al., 1989; Harvey &

Siddique, 1999).

ill
 Tabie:7.1
Summary Statistics of Future Index Return, Volume & Open Interest
RETURN VOLUME OI
Mean 0.000531 546122.1 14619450
Median 0.001045 318188.8 10897000
Maximum 0.161947 3091293 44400050
Minimum -0.162581 51.87 5000
Std. Dev. 0.01844 573910.8 12970229
Skewness -0.486002 0.940613 0.396376
Kurtosis 11.53451 3.166897 1.729823
Jarque-Bera 7138.467 345.0944 216.8949
Probability 0 0 0
ARCH LM (10) 244.2308
(0.0000)
Sum 1.233276 1.27E+09 3.39E+10
Sum Sq. Dev. 0.789245 7.64E+14 3.90E+17
Observations 2322 2322 2322

Therefore, we conducts ARCH LM test using Engle’s (1982) methods for

arch effect. The test results show that the LM statistic is significant at better

than the 1% level, implying that the Nifty Index Future return series are

heteroscedastic. In fact, the p value given below the parameter estimate is

well below 0.01, strongly rejecting the null hypothesis of homoskedasticity.

Open interest can take on rich time to maturity pattern. Milonas.B (1986)

considers time to maturity pattern in open interest for various markets. He

finds that for liquid future contract of immediate maturity, there can be

different time to maturity patterns, with more distant contracts having more

or less open interest than nearer to expiration. Thus we might expect to see a

time to maturity effect in volume series.

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 In order to adjust for this documented shift in both mean and variance of

the volume and open interest series we run regression on time to expiration.

The time to maturity variable is simple decreasing factor. In our sample data,

25 days is the maximum days to expiration and it decreases to 0 (zero) days,

being the day of expiration.

Following Campbell. J.Y, Grossman. S. J and Wang. J.C (1993) we

measure the turnover (volume) and open interest series in logs rather than in

absolute units to remove low frequency variation from the level and variance

of both the series. Also following Gallant. A. R; Rossi. P. E and Tauchen. G;

(1992) we introduce t and t2 time trend variables to remove the liner and

quadratic trend in volume and open interest series.

We run the following regression models to bring stationarity in volume

and open interest series for further analysis in the study.1

LogOIt = a0 + ajt + a2t2 + £ a3TTEi + yt (7.2)

/=0

LogVt = ao + a}t + a3t2 + £ a3TTEi + vt (7.3)

i=0

Where,

1 The volume and open interest series are tested for unit root in their levels using Augmented Dicky

Fuller (ADF) test; the results can not reject the null hypothesis of a unit root. Again the residual of

the equation (7.2) and (7.3), taken as volume and open interest series respectively for further

analysis, are tested for unit root; reject the null hypothesis of a unit root.

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 t (linear trend variable) = {t/2324)

t2 (Quadratic trend variable) = {t/2324)2

LogOl= log open interest at time t

LogVt = log volume at time t

TTEi = Time to Maturity effect from 25days to expiration to zero day (the

day of expiration.

yt = the residual of equation (7.2) represents the detrended open interest

adjusted for time to maturity effect.

vt = the residual of the equation (7.3) represents the detrended volume

adjusted for time to maturity effect.

(We have tested stationarity of both the residual series of equation (7.2)

and (7.3) by applying Augmented Dickey Fuller test. The results of the test

are presented in Table-7.3. Both y, and v, represent open interest and volume

series respectively are stationary as per the result of the test and used in our

study for further analysis. However we use the return series without any

seasonal adjustment because we find so such significant effect of time to

maturity.

In the Table-7.2, we present the regression statistics of the equation (7.2)

and (7.3).

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 Table-7.2
Regression Statistics
R2 F-statistic Prob(F-statistic)
Equation (7.2) 0.966109 2310.003 0.00*
Equation (7.3) 0.957206 1812.59 0.00*

* Accepted at 1% level of significance that betas are significant and not equal to zero. That means iogoi and

logv series has some seasonal tendency as far as TTE is concerned.

Table-7.3
Test of Unit Root
Panel A
Null Hypothesis: NEWOI has a unit root
Exogenous: Constant
Lag Length: 0 (Automatic based on SIC, MAXLAG=26)
t-Statistic Prob.
Augmented Dickey-Fuller test statistic -10.1579 0*
Test critical values: 1% level -3.433001
5% level -2.862597
10% level -2.567378
Panel B
Null Hypothesis: NEWVOL has a unit root
Exogenous: Constant
Lag Length: 6 (Automatic based on SIC, MAXLAG=26)
Augmented Dickey-Fuller test statistic -5.925845 0*
Test critical values: 1% level -3.433009
5% level -2.8626
10% level -2.56738
* The null hypothesis that open interest series (Yt) an<J volume series (Vt) are stationary can not be rejected at 1% level.

The descriptive statistics in the Table-7.1 suggests that, Nifty Index Future

Return series are not normally distributed and are characterized by excess

kurtosis. Also, the return series exhibited significant heteroscedasticity,

suggesting the use of the Generalized ARCH (GARCH) model Bollerslev

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(1986) is appropriate. Therefore, in order to study the relation between future

index return volatility, volume and open interest, we use augmented GARCH

framework. The GARCH (1,1) model has been shown to be adequate for

examining the relation between return volatility and volume (Bollerslev,

1986,1987); Lamoureux & Lastrapes, 1990; Najand & Yung, 1991, etc).

Finally, we estimate the GARCH (1, 1) model using the adjusted volume and

open interest series and the level of the return series as appropriate.

We specifically use the following GARCH (1,1) models.

Rt- fi + Rt.i+ st (7.4)

et/It.j-N&hJ (7.5)

ht = ao + ais2t-i + a2ht.j (7.6)

ht = a0 + aje2^ + a2ht.1+ yiVH (j = 0, 1) (7.7)

ht = a0 + a,s2t.]+ a2ht.]+ @I(OI)t_j + ®2VH (j = 0, 1) (7.8)

In equation (7.7) and (7.8),y will take 0 for current volume and open interest

and 1 for lagged volume and open interest.

For equation (7.8) we have followed Girma and Mougoue (2002).Further,

Bessembinder and Seguin (1993) states that, open interest measures are

pertinent along with volume. Since many speculators are “day traders”, who

don’t hold open positions over night, open interest as of the close of the

trading likely reflects primarily hedging activity and ,thus, proxies for the

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amount of uninformed trading. Using open interest in conjunction with

volume data may provide insights into the price effects of market activity

generated by informed versus uninformed traders or hedgers and speculators.

Where, Rt is the nifty future index return series, V or OI are the adjusted

volume or open interest of the nifty index future contract on a given day and

(y, the coefficient) their respective parameter estimate. <£/ and 02 in equation

(7.8) are parameter estimates for open interest and volume when both

volume and open interest are entered simultaneously in the conditional

variance equation. Note that equation (7.7) is also used to model the relation

between open interest and volatility by simply substituting open interest (OI)

for volume (V).

As Table-7.1 shows that nifty index future return series are non-normally

distributed, the model given by equation (7.4) to (7.8) is estimated under the

assumption that et follows a conditional normal distribution which is

conditioned on the available information (/,_/) at time t-1. The empirical

findings are presented and discussed in the next section.

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7.4 Empirical Results

Table-7.4

GARCH (1,1) Estimate for Nifty Index Future Return

Coefficient Std. Error z-Statistic Prob.
F 0.001264 0.000275 4.591327 0
ao 0.000009780 1.08E-06 9.055034 0
ai 0.166674 0.011824 14.09654 0
02 0.811876 0.012033 67.47172 0
ai+02 0.97855

The results of simple GARCH (1, 1) model [Equation-(7.6)] parameter

estimates of Nifty Index Future Return are presented in the Table-7.4. The

index return volatility shows high level of persistence as U]+a2 =.97855.

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 Table-7.5

GARCH (1,1) Estimate for Nifty Index Future Return with Volume
Coefficient Std. Error z-Statistic Prob.
Panel A: GARCH (1,1) Estimate for Nifty Index Future Return with Current
Volume
p 0.001265 0.000291 4.344016 0
do 2.00E-05 1.77E-06 11.26785 0
ai 0.173495 0.014893 11.64928 0
m 0.769878 0.014934 51.55146 0
Y 1.98E-05 2.19E-06 9.024093 0
ai+Q2 0.943373
Panel B: GARCH (1,1) Estimate for Nifty Index Future Return with Lagged
Volume
F 0.001185 0.000292 4.060099 0
do 1.33E-05 1.45E-06 9.155124 0
ai 0.158279 0.012232 12.94012 0
02 0.806935 1.28E-02 63.10163 0
Y 8.47E-06 2.00E-06 4.235588 0
ai+02 0.96521

Using volume as an explanatoiy variable in the conditional variance

function [Equation (7.7)], Table-4 shows the GARCH (1,1) estimates for the

Nifty Index Future Return. Panel A of the Table-7.5 shows that current

volume has a significant explanatoiy power for Nifty Index Future return

volatility. Because there is a greater reduction in volatility persistence from

0.97855 to 0.9433. Also the coefficient of the contemporaneous average

volume in the conditional variance equation, y, is statistically significant at

1% level. Panel B of the Table-7.5 shows that lagged volume has a

significant explanatory power for nifty index future return volatility when it

is used as an explanatory variable. The coefficient of the lagged volume in

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 the conditional variance equation [Equation (7.7)], is statistically significant

at the 1% level. Furthermore, the introduction of lagged volume in the

conditional variance equation reduces the observed persistence, as measured

by (ai+a2), from 0.97855 to 0.9652.

In summary, when entered separately, the contemporaneous and lagged

volume variables have a significant explanatory power for the volatility of

returns for nifty index future. However, the persistence of volatility remains

high thereby, suggesting that volatility shocks to nifty index future return

tend to persist and affect future volatility for longer period of time.

Table-7.6
GARCH (1,1) Estimate for Nifty Index Future Return with Open Interest
Coefficient Std. Error z-Statistic Prob.
Panel A: GARCH (1,1) Estimate for Nifty Index Future Return with Current Open
Interest
p 0.001218 0.000281 4.32927 0
do 9.86E-06 1.18E-06 8.374932 0
ai 0.16571 0.011657 14.21601 0
ai 8.13E-01 1.20E-02 67.57853 0
Y 4.29E-06 1.57E-06 2.739914 0.0061
ai+Q2 0.9789
Panel B: GARCH (1,1) Estimate for Nifty Index Future Return with Lagged Open
Interest
F 0.001217 0.000281 4.332944 0
do 9.76E-06 1.16E-06 8.405276 0
ai 0.165279 0.011615 14.22996 0
<X2 0.813967 0.011972 67.9872 0
Y 3.43E-06 1.47E-06 2.33159 0.0197
ai+a2 0.9792

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(y is the coefficient of current open interest in Panel A and of lagged open

interest in Panel B)

Table-7.6 shows the estimates of the GARCH (1, 1) model for the

nifty index future return using open interest as an explanatory variable in the

conditional variance function [Equation (7.7)]. Panel A of the Table-7.6

shows that current open interest has marginal or no explanatory power for

the nifty index future return volatility. The coefficient of the

contemporaneous open interest in the conditional variance equation, y, is

statistically significant at 1% level. Panel B of the Table-7.6 shows the

impact of the lagged open interest variable on the volatility of the returns for

Nifty Index Future. The coefficient of the lagged open interest in the

conditional volatility equation, y, is statistically significant at 1% level. The

findings show that, the inclusion of lagged open interest as explanatory

variable in the conditional variance equation leads to marginal increase in

volatility persistence.

In summary, when entered separately, the contemporaneous and lagged

open interest variables have marginal explanatory power for the volatility of

returns for Nifty Index Future Return. Akin to in the case of volume, the

persistence of volatility for nifty index future returns and open interest

(current or lagged) reduces GARCH effect in return volatility marginally.

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The persistence of return volatility suggests that volatility shocks to nifty

index return persist and affect future volatility for a longer period of time.

Table-7.7 shows the result of estimating the GARCH (1,1) model for the

Nifty Index Future Return using volume and open interest simultaneously as

explanatory variables. In particular, Table-7.7 presents the results of

exploring the explanatory power of volume and open interest when they are

entered simultaneously in the conditional variance equation [Equation (7.8)].

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 Table-7.7
GARCH (1,1) Estimate for Nifty Index Future Return with Volume and Open Interest

Coefficient Std. Error z-Statistic Prob.

Panel A: GARCH (1,1) Estimate for Nifty Index Future Return with Current Volume
and Open Interest
p 0.00126 0.000293 4.300088 0
do 1.98E-05 1.75E-06 11.29331 0
ai 0.173258 0.014846 11.67066 0
d2 7.71E-01 1.49E-02 51.59022 0
01 -1.65E-06 3.29E-06 -0.503499 0.6146
02 1.99E-05 2.26E-06 8.807273 0
ai+02 0.9440
Panel B: GARCH (1,1) Estimate for Nifty Index Future Return with Lagged Volume
and Open Interest
P 0.000548 0.00062 0.88316 0.3771
do 2.10E-04 9.40E-06 22.35035 0
d1 0.131048 0.021187 6.185272 0
02 0.496913 0.027513 18.06126 0
01 0.00005970000 5.09E-06 11.72933 0
02 0.00008530000 2.03E-05 4.208263 0
dl+Q2 0.62796100000

Panel A of the Table-7.7 reveals that when current volume and open

interest are entered in the conditional variance equation simultaneously, only

current volume achieves statistical significance at the 1% level. In this case

the persistence of volatility, as measured by (ai+a2) also declines from

0.97855 to 0.9440. However, the persistence of volatility of nifty index

future return remains and past volatility can explain current volatility. Thus,

current volume and open interest don’t remove the GARCH effect.

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 Panel B of the Table-7.7 shows that, when lagged volume and lagged

open interest are included as explanatory variable in the conditional variance

equation, the coefficients of both the lagged open interest (®i) and lagged

volume (<X>2) are significant at 1% level. Furthermore, the results in the Panel

B of the Table-7.7 show that, the persistence of volatility as measured by

(<Xi+a2) decreases dramatically from 0.97855 in Table-7.4 to 0.6279 for the

Nifty Index Future Return. Thus, it appears that including lagged volume and

lagged open interest in the conditional variance equation has greater power

of reducing the persistence in volatility for the Nifty Index Future return than

the current volume and open interest either separately or jointly. These

findings seem to support the Sequential Information Arrival hypothesis of

Copeland (1976). Finally, these findings also suggest a degree of market

inefficiency for nifty index future and are consistent with previous research

on price variability and volume and/or open interest (see, e.g., Foster, 1995;

Fujihara and Mougoue, 1997).

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7.5 Conclusion

The study of this chapter finds that contemporaneous volume provide

significant explanation for Nifty Index Future Return volatility than open

interest when entered separately. Similarly, the lagged volume has

significant explanatory power than lagged open interest for volatility of Nifty

Index Future Return. Furthermore, the study also finds that lagged volume

and lagged open interest when entered in the conditional variance, equation

simultaneously, provide significant explanatory power than

contemporaneous volume and open interest and reduce the persistence of

volatility dramatically. These findings are consistent with previous research

on price variability and volume and/or open interest and seem to support the

Sequential Information Arrival hypothesis of Copeland (1976). Finally, these

findings also suggest a degree of market inefficiency for the Nifty Index

Future.

As far as source(s) of uncertainty (volatility) for Nifty Index Future return

is concerned, the empirical results show that contemporaneous and lagged

volume and open interest are significantly related to the volatility of the

Nifty Index Future return. The findings of the study in the current chapter

have practical implication for speculators, hedgers as it is well known that

successful hedging and speculative activities in the future market depends

critically on the ability to predict price movements. As per the findings that

current and lagged volume and open interest affect volatility implies that a

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short-term improvement in predicting future price movements can be

achieved using these variables. This improvement of short term future price

predictability should lead to the construction of more accurate hedge ratios

and different investment and trading strategies.

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