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The futures market trading was introduced in Indian financial markets in June 2000
and options index commenced from June 2001, and subsequently trading of the options
and futures on individual securities commenced from July 2001 and November
2001, respectively. The futures derivative trading on stock indexes as well as individual
stocks has grown rapidly since its very inception and performs important economic
functions such as price discovery, portfolio diversification and opportunity for market
participants to hedge against the risk of adverse price movements. Hence, the movements of
spot market price have been largely influenced by speculation, hedging and arbitrage
activity of futures markets. Thus, understanding the influence of one market on the other and
the role of each market segment in price discovery is the central question in
market microstructure design and has become an increasingly important research issue
among academicians, regulators and practitioners alike, as it provides an idea about the
market efficiency, volatility, hedging effectiveness and arbitrage opportunities, if any.
Price discovery is the process of revealing information about future spot prices through
the futures markets. The essence of the price discovery function hinges on whether
new information is reflected first in changes of futures prices or changes of spot prices.
Hence, there exists a lead-lag relationship between spot and futures markets through
information dissemination. All the information available in the marketplace is
immediately incorporated in the prices of assets in an efficient market. So, new information
disseminating into the market should be reflected immediately in spot and futures prices
simultaneously. This will lead to perfect positive contemporaneous comovement between the prices
of those markets and there will be no systematic lagged
response, and therefore, no arbitrage opportunity. This prediction arises directly from the
Cost-of-Carry (COC) model of futures pricing which postulates
that:
Accordingly, there exist diversified theoretical arguments pertaining to the
causal relationship between spot and futures markets by information dissemination. The
main arguments in favor of futures market leading spot market are mainly due to the
advantages provided by the futures market such as higher liquidity, lower transaction costs,
lower margins, easy leverage positions, rapid execution, and greater flexibility for short
positions. Such advantages attract larger informed traders and cause the futures market to react
first when market-wide information or major stock-specific information arrives. Thus,
the futures prices lead the spot market prices. On the other hand, the low-cost
contingent strategies and high degree of leverage benefits in futures market attract larger
speculative traders from the spot market to a more regulated futures market segments. Hence,
this ultimately reduces the informational asymmetries of the spot market by reducing
the amount of noise trading and helps in price discovery, improves the overall market
depth, enhances market efficiency, and increases market liquidity. This makes spot market
to react first when market-wide information or major stock-specific information arrives. |
