Korea Capital Market Institute

The KOSPI turmoil occurred at the closing auction on Nov. 11, 2010 not only revealed the weakness of settlement risk, but also showed a possibility of price manipulation in KOSPI200 derivatives markets. Regarding the market crash on that expiration day, this report examines the expiration day effects of the KOSPI200 futures and options market. And we analyse the characteristics of settlement procedures across world-wide derivative markets. To mitigate the expiration day effects, we also discuss the improvements of settlement procedures. The expiration day effects of derivatives on their underlying assets include the significant change of trading volume, volatility, return, and price reversals of underlying assets. The expiration day effects are caused by arbitragers who have to liquidate their underlying positions at the settlement day. Actually, a lot of literatures found the existence of expiration day effects including the significant price reversals in US, UK, Japan, and so on. Our empirical results show that the expiration day effects on KOSPI200 derivatives market are significantly observed in option maturity days compared to the other days. Both the trading volume and volatility of underlying assets in option maturity days are significantly higher than those in ordinary days, and the return of underlying asset is significantly lower. The price reversals in option maturity days are relatively low compared to the level in ordinary days. Also, time series analysis shows that the expiration day effects has been consistently observed since the inception of KOSPI200 derivatives market. Meanwhile, it is difficult for the other countries to find the expiration day effects which was observed at the beginning. To mitigate the expiration day effects, US and Japan regulators and stock exchanges decided to change the settlement procedure from the closing auction price to the special opening price. UK and Germany use the mid-time auction based on the predefined trading periods. The other countries adopted the closing auction price, but now uses the opening price or the average price. There are no major equity index derivatives which are settled using a closing auction price except KOSPI200 futures and options. If KRX changes the final settlement price, alternative methods could be an opening auction price, an average price during some periods, or a mid-time auction. Assuming that the average price based on a longer period mitigates the expiration day effects, the average price as a final settlement price will be more helpful than the opening auction or mid-time auction to alleviate the expiration day effects. However, changing the settlement price could not only decrease the program trading, but also increase the costs of IT-infra improvements.