Lead-lag relationship between futures and spot FX market in India

Abstract

PurposeThe purpose of this paper is to study the lead-lag relationship between the futures and spot foreign exchange (FX) market in India to understand the price discovery mechanism and the relationship between these two markets.Design/methodology/approachThe estimation of lead-lag relationship is realized in three steps. First unit root and stationarity tests (Augmented Dickey-Fuller, Phillips-Perron, and Kwiatkowski-Phillips-Schmidt-Shin) are applied to check the stationarity of the data. Second, cointegration tests (Engle and Granger’s residual based approach and Johansen’s cointegration test) are applied to determine long run relationship between the markets. Third, error correction estimation is carried out by applying Vector Error Correction Model (VECM) to determine the leading market.FindingsThe study finds that there is a long run relationship between the futures and spot market where the futures market has emerged as the leading market for the four currencies studied in the paper.Originality/valueMajorly, the studies on Indian FX market limit themselves to identifying the efficiency of the market and the studies which talk about the lead-lag relationship focus on the Indian stock market. This paper enhances the existing literature on Indian FX market by exploring the less explored subject of the lead-lag relationship between futures and spot FX market in India.