Price Discovery and Volatility Spillover between Spot and Futures Markets: Evidence from India

The present study investigates the role of information in price discovery function and volatility spillover in Nifty and SP Kawaller et al. , 1990; Chan et al ., 1991; Lien and Tse, 2000; Yang et al. , 2001; and Raju and Karande, 2003). This price discovery function implies that prices in the futures and spot markets are systematically related in the short run and/or in the long run. In the cointegration jargon, the price discovery function implies the presence of an equilibrium relation binding the two prices together. If a departure from equilibrium occurs, prices in one or both markets should adjust to correct the disparity. Herbst et al. (1987) argue that futures market is commonly observed for updated price more frequently than the spot market. Investors with strong beliefs about the direction of market, trade in futures rather than spot, because of low transaction cost and high degree of leverage. Such trading, moves futures first and pulls spot price by means of arbitrage, creating a lead-lag relation. Considering the relation between futures and spot price, Kawaller et al. (1990), put forward the general principle that spot price is affected by past spot price, current and past futures price and other market information. Similarly, futures price is affected by past futures price, current and past spot price and other market information. Thus, causality is likely to be bidirectional. They further argued that the lead-lag pattern between futures and spot prices changes as new information arrives. Each may lead the other as market participants shift information for clues that are relevant to their position which may be spot or futures. The second direction investigates volatility spillover between spot and futures markets. There are some studies which have examined this issue (for instance, Koutmos and Tucker, 1996; Fleming et al., 1998; and Raymond and Tse, 2006). It has been argued that volatility surprises in one market will spillover to volatility in another market, in a subsequent trading period. …