Academic journal article Quarterly Journal of Finance and Accounting

Trading Behavior and Price Discovery during the S&P 500 Rollover

Academic journal article Quarterly Journal of Finance and Accounting

Trading Behavior and Price Discovery during the S&P 500 Rollover

Article excerpt

Introduction

Recurring contract terminations provide an excellent laboratory to investigate the informational content of trades and price discovery in index futures. (1) We use high frequency transactions data from 1996 to 2001 and calculate several measures to take advantage of the peculiarities of this rollover period, which centers around the deterministic shift in volume from one contract to the next. These measures include effective bid/ask spread, volume, price volatility, price discovery across futures contracts, and market makers' income. While calculations of trading spreads, volumes, volatility, and income are straightforward, price discovery requires a more elaborate investigation. Hasbrouck (1995) defines the contribution to the price discovery process from related markets as the information share, which is the contribution from each price series to the variance of their common factor. Gonzalo and Granger (1995) use common factor components to measure price discovery. We calculate both Hasbrouck's information share and Gonzalo and Granger's common factor components in this study for different futures contracts during the rollover period to explore price discovery among the contracts.

In a paper closely related to ours, Kawaller, Koch, and Peterson (2001) examine the futures rollover period and find that the volume/volatility relationship is characterized by a surprising inverse relationship, looking across contract maturities. They also make the observation that there appears to be a corresponding shift of locals from trading the nearby to trading the next-out contract at the redesignation. Our empirical evidence builds on their findings, using a more detailed data set to both reaffirm and extend their basic results. Like Kawaller et al. (2001) we find a sizeable jump (as compared to a gradual change) in volume from the nearby to the next-out contract on the redesignation date, while volatility in the nearby contract also rises the moment it loses its lead status. Correspondingly, volatility falls and volume rises in the next-out contract the moment it is designated as the lead contract. There is also a jump in the number of locals from trading the nearby to trading the next-out contract at the redesignation, verifying the assertion of Kawaller et al. (2001).

These results confirm that our detailed data set and that used by Kawaller et al. (2001) do not conflict. The goal of this study, however, is to investigate the information content of trades and contracts during the futures rollover period. Kawaller et al. (2001) observe that the traditional information models indicate a positive volume and volatility relationship, and this is the puzzle that we are investigating. We further investigate the dynamics of price discovery across the nearby and next-out contract during the redesignation period, an analysis that extends Kawaller et al. (2001) in a natural direction. We also investigate some of the microstructural implications of the rollover period, in lieu of the informational role in microstructure models.

Based on our empirical evidence, both Hasbrouck's (1995) information shares and Gonzalo and Granger's (1995) common weights suggest that the nearby contract loses its price discovery leadership immediately upon redesignation. In other words, the designated lead contact is also empirically the price discovery leader. As a result, trading in the non-lead contract, which benefits from the price discovered in the same pit in the lead contract, should reveal less information asymmetry and by extension be subject to less of an information premium according to basic market microstructure. The premium would be exhibited in the bid ask spread, but we find little effect there. When market makers' per contract income is investigated, however, we find that market makers who specialize in trading the non-lead contract earn a high return from trading the non-lead contract. We are left with the argument that the bid ask premium comes directly from inventory issues associated with the non-lead contract rather than information asymmetry. …

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