Financial derivatives introduction and stock return volatility in a emerging market without clearinghouse: the Mexican experience

Abstract

This paper introduces an alternative methodology to test whether financial derivatives introduction affects underlying stock return variace. Previous tests did not address the problema that variance changes systematically through time for individual firms as their leverage, investment opportunities, and other characteristics change. Our test consists in utilizing the GARCH process to generate time-series measure of stock return vilatility, we then use these series to determine whether stock return variances change permanently when a financial derivative is introduced. We apply this methodology to the Mexican case which we consider of interest given that Mexican derivatives are traded in the Mexican Stock Exchange (MSE), not in an Option Exchange, and the credit risk is covered with a delte-hedging formula, not through a clearinghouse. Empirical results suggest that derivatives introduction does not reduce Mexican stock return volatilities ; this result holds even before the well known Mexican financial crisis of 1994.