An Econometric Study of Lead-Lag Relationship between Futures and Spot Markets in India

Abstract

The temporal relation between stock index and index futures has been an area of interest to academicians, regulators, and practitioners alike as it gives an idea about the efficiency of the market, its volatility, and arbitrage opportunities, if any. The issue of price discovery on futures and spot markets and the lead-lag relationship are topics of interest to traders, financial economists, and analysts. Although futures and spot markets react to the same information, the major question is which market reacts first. This paper examines the lead-log relationship between futures and spot markets in India. For both available stock index futures contracts, i.e., NSE Nifty and BSE Sensex of National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) respectively, we employ a Bivariate GARCH model to explain price discovery of futures market over the period from July 2000 to March 2007. Empirical results confirm that futures market plays a price discovery role, implying that futures prices contain useful information about spot prices (in line with similar findings in the literature). We evidence a bidirectional lead-lag relationship between spot and futures prices in both the stock indices and this is relatively stronger in NSE Nifty than in BSE Sensex. Futures markets are more informationally efficient than underlying stock markets in India during the period 2001-7. These findings are helpful to financial managers and traders dealing with Indian stock index futures.