Investigating the effect of single stock futures trading on the volatility of underlying stocks moderated by macroeconomic factors in the Kenyan market

Abstract

The introduction of Single Stock Futures (SSFs) in the Kenyan stock market aims to provide a tool for hedging, price discovery, and liquidity enhancement. SSFs are a tool for risk management, particularly investors hedging their positions in underlying market. SSFs also breed speculators which might lead to significant price fluctuations thus volatility. Volatility is one of the main drivers of trading, it influences investor confidence and overall stability of equity markets. The general objective of this study was to investigate if single stock futures (SSFs) trading affects the volatility of the underlying stocks in the Kenyan futures market (NSE NEXT). Specifically, the study sought to analyze the short-term effects of SSF trading on the volatility of the underlying stocks at the Nairobi Securities Exchange (NSE), to analyze the long-term effects of SSF trading on the volatility of the underlying stocks at the Nairobi Securities Exchange (NSE) and to examine the moderating effect of macroeconomic factors on the relationship between single stock futures (SSFs) and the volatility of the underlying stocks at the Nairobi Securities Exchange (NSE). The study was guided by Efficient Market Hypothesis (EMH), Information Flow Hypothesis and Volatility Feedback Theory. This research adopted a positivist approach to ensure objectivity in addressing the research questions. The study used causal research design. The population of this study includes the 10 single stocks listed and trading on the NSE NEXT from 4th July 2019 to 31st July 2024. The study carried out a complete enumeration of the ten NSE NEXT listed firms that traded in single stock futures between 4th of July 2019 to 31st of July 2024. The study utilized secondary quantitative data obtained from the NSE and Central bank of Kenya (CBK). The data included daily closing share prices and trading volumes for both the underlying stocks and the single-stock futures market, inflation rate and interest rates. Observations cover two periods: January 2019 to June 2019, representing the pre- SSF phase (for stocks that began trading in July 2019), and July 2019 to July 2024 representing the post-SSF trading phase. The data was prepared using Microsoft Excel and analyzed using STATA 13. Exponential GARCH (EGARCH) model was used to measure volatility of the underlying stocks. Vector Auto Regression (VAR) model was employed to test the short-term and long-term causality between single stock futures trading and volatility of the underlying stocks. To validate the results and ensure robustness of the findings, this research employed various diagnostic tests including; ARCH test and t-test for EGARCH model, Unit root test, Granger causality test and cointegration test for volume turnover and VAR model. The study concludes that introduction of SSFs had a significant positive effect on stock return volatility and trading volumes for Safaricom and Equity Holdings, suggesting that SSF trading increased market activity and speculative behavior in the short run. The study also concludes that in the long term, the analysis identifies a significant negative effect of SSF trading on stock return volatility, implying a stabilizing influence of derivatives on price fluctuations over time. This is supported by the presence of significant error correction terms in VECM models for firms like Safaricom, KCB, and Equity Holdings, confirming long-run equilibrium relationships. Furthermore, the analysis of moderating effects highlights a significant positive interaction effect between inflation and SSF trading volume on stock return volatility. This indicates that inflation amplifies the volatility-inducing impact of SSF trading, particularly in speculative environments. The findings suggest that macroeconomic factors like inflation can alter the volatility dynamics induced by SSFs. Since inflation is found to intensify the volatility of stock returns in markets with SSFs, policymakers should consider implementing inflation-targeting measures to reduce uncertainty and stabilize the financial markets.