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The role of futures markets in providing an efficient price discovery mechanism has
been an area of extensive empirical research. The existence of price discovery and
market efficiency is the centerpiece of market microstructure design and of utmost importance
for the practitioners, regulators and academicians. Price discovery refers to the
process through which financial markets converge and reach the efficient equilibrium price.
The essence of the price discovery function of futures market hinges on whether
new information is reflected first in changed futures price or in changed spot price. In
a perfectly efficient and frictionless market, futures price should move concurrently with
the underlying spot price without any lead or lag in price movements across markets.
Futures price should be an unbiased estimator of the future spot price at the expiration
date. However, due to market friction such as transaction cost or market microstructure
effects, futures market processes information faster than the spot market. Futures price leads
spot price, indicating that the futures market performs the price discovery function. It
illustrates how rapidly one market incorporates information relative to the other, and also
indicates the efficiency of their functioning as well as the degree of
integration between the two markets.
The study of dynamic price relationship between equity spot and futures is useful
for the traders, regulatory bodies, practitioners, and academicians for several reasons, such
as price discovery, hedging and arbitrage opportunities. Since the most notable objectives
of security market design are optimal price discovery and market efficiency, it is essential
to determine the nature and location of price discovery. The implementation of
arbitrage trading strategies must take into account the lead-lag relationship between cash
and futures markets. It provides valuable information to the traders regarding the
prospective direction of price movement in the cash market, which in turn directs the trader's
future actions. Mispricing of futures provides especially short-run riskless
profit-making opportunity to the arbitrageurs. Therefore, their actions will result in correcting
the magnitude of basis. But if mispricing is governed by factors other than market risk, it
may spoil the market sentiment and will contribute to information asymmetry. This in
turn may damage the trader's confidence. Efficient price discovery in the futures market
has critical implications, especially for the hedgers who want to reduce the risk
element contained in the cash market portfolio by taking reverse positions in the futures
market. Since, both markets are related to each other through the cost-of-carry
phenomenon, movement of basis may play a critical role. |
