The Impact of Derivatives Hedging on Stock Trading Volume and Return Volatility: Evidence from the ELW Market in Korea
Authors:   Asia-Europe Perspective Association, Lee Dong-Hoon , Ahn Hee-Joon 
Published: June 2018

This study investigates the link between derivatives trading and stock trading by examining the impact of ELW hedging activities on stock trading volume and return volatility. We use daily ELW and stock trading information on the Korea Exchange. Our data span 585 trading days from January 12, 2009, to May 20, 2011.
Most previous studies use ELW issue data in their analysis. Using the nominal volume (i.e., ELW issue data), however, is subject to limitations because only as much as 5 percent of the total volume issued is ever traded in the market. We overcome this issue by using the actual ELW trading data and focus on the direct linkage between the ELW market and the stock market through Delta hedging amounts of ELW-sold positions, measured by gamma. We run both time-series and cross-sectional regressions with ELW gamma as our key independent variable and stock trading volume and return volatility as the dependent variables.
We test two hypotheses: (1) complete market hypothesis and (2) hedging effect hypothesis. The complete market hypothesis posits that the introduction of derivative securities offers new investment opportunities for investors, making the market more complete. As investors engage in speculating, arbitraging, and hedging activities using derivative securities, trading intensifies and more information is channeled in the market, leading to improved price discovery. The testable implications are that ELW trading increases the trading volume and decreases the volatility of the underlying stock. Meanwhile, the hedging effect hypothesis focuses on the effects of dynamic hedging by ELW issuers. According to the hypothesis, dynamic hedging by issues results in increased trading of the underlying stock. It also increases return volatility as the ELW issuer purchases (sells) more shares as the stock price rises (falls) to hedge its position. In sum, the hedging effect hypothesis predicts that gamma increases stock trading volume and decreases stock return volatility.
Our empirical findings are summarized as follows. Although there are some minor differences in the levels of statistical significance. both time-series and cross-sectional regressions offer strong evidence that ELW gamma increases stock trading volume and decreases stock return volatility. These results are consistent with the complete market hypothesis, which states that derivatives trading offers more diverse trading channels for market participants and enhances price discovery thus improving overall efficiency of the stock market.
Our study contributes to the literature by using the hedging information retrieved from ELW trading and thereby providing clearer evidence on the role of ELW trading on the underlying market. ELW trading and derivatives trading in general have recently been criticized in Korea as means of excessive speculation by individual traders, thus causing an unhealthy trading environment. A series of measures have ensued by policy makers that restrict derivatives trading. We hope that the findings in our study shed some light on the positive role of ELW trading. Our results have strong indication that ELW markets help enhance the efficiency of stock markets and improve their trading environment.