Does contract size matter for price discovery and risk management in stock index futures?


In an effort to increase the liquidity and accessibility to the investors, National Stock Exchange of India (NSE) had reduced contract size of its Nifty index futures two times from 200 to 100 and, subsequently, to 50 units. How does this change in contract size of index futures impact the informed and hedge based trading, thereby contributing to the twin objectives of price discovery and risk management, respectively? VAR model is applied to daily return volatility, volume and open interest to study the impact. Significant feedback relationship between volume and volatility following the reduction in contract size establishes the informational trading and price discovery. However, no causality from volatility to open interest implies contract size is not a determinant of hedging. But significant causality from open interest to volatility is establishing the non-informational and liquidity trading. So stock exchanges should consider the appropriate lot size before going for introducing new futures contract

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