A Note on the Relationship Between the Spot and Futures Markets for Common Stock

The concern over how trading in futures contracts affects the spot market for underlying assets has been an interesting subject for investors, market makers, academicians and regulators alike. With the introduction of futures contracts in financial markets, the desirability of such derivative instruments for the efficient functioning of those markets were questioned. Existence of futures contracts in any market is expected to provide the investors in spot (cash) markets with means of hedging risk. In addition, the futures markets should be the vehicle for price discovery in the spot market for underlying assets. Yet over years, especially with the experience in financial derivative instruments, there seems to be some concern for the undesirable impact of these markets on spot markets. The critics argue that introduction of futures contracts in financial markets has increased the volatility in spot markets and attracted more speculators than hedgers so as to destabilise cash markets in some instances. The impact on liquidity, according to the critics, may not be favourable either. The stock market crash of October 1987 strengthened the criticisms, as the rapid and persistent decline in prices in a very short time period were at least partially blamed on program trading strategies such as portfolio insurance and index arbitrage. These strategies are well known for their dependence on derivative instruments like stock index futures and options. The objective of this note is to review the literature on the impact of stock index futures on stock markets. Specifically, the evidence for change in overall volatility and liquidity after the introduction of stock index futures is reviewed. In addition, theoretical pricing of index futures and arbitrage opportunities, as well as the lead-lag relationship between spot and futures markets are addressed.