Academic journal article Business and Economics Research Journal

Intraday Lead-Lag Relationship between Stock Index and Stock Index Futures Markets: Evidence from Turkey

Academic journal article Business and Economics Research Journal

Intraday Lead-Lag Relationship between Stock Index and Stock Index Futures Markets: Evidence from Turkey

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Price-risk protection requires a stable relationship between spot prices and futures prices. Large deviations from this relationship make it difficult to make optimal decisions regarding futures prices, increase the cost of risk protection for economic units and decrease efficiency in risk management. The complete breaking off of the relationship between spot and futures markets means completely independent movements of two markets, and in this case the use of futures markets in risk management and their price discovery role might prove impossible. Knowing how spot and futures markets are related will guide especially the transactions aimed at risk protection and aid all market participants in making rational decisions.

Theoretical foundations comprising the relationship between spot and futures markets are efficient markets hypothesis, cost of carry model (Hasan, 2005) and arbitrage. Fama (1970) defines an efficient market as the market where asset prices reflect all available information completely. Efficient markets hypothesis suggests that all available information will simultaneously be reflected both in spot prices and futures prices, and price movements in both markets be identically and independently distributed, resulting in efficient operating of financial markets. In an efficient capital market where interest rates and dividend yields are not stochastic, the main tenet of "cost of carry model" is a perfect relationship between simultaneous returns of futures and spot markets, hence no lead-lag relationship between them (Stoll and Whaley, 1990; Hasan, 2005). On the other hand, arbitrage steps in as a mechanism that brings it back to the cost of carry relationship both in price formation process and when the relationship between spot and futures markets to be established by the cost of carry model is disrupted.

In efficient and uninterrupted stock markets and futures markets where the interest rates and dividend yields are non-stochastic and no transaction costs and arbitrage opportunities exist, the cost of carry relationship must be valid at any time over the life of futures contract (Cornell and French, 1983; Stoll and Whaley, 1990). Under efficient market conditions where market imperfections do not exist, spot and futures market changes (returns) are simultaneously and perfectly related, and particularly one market would not lead another (Brooks, Rew and Ritson, 2001).

Spot prices and futures prices are different from each other due to the difference in the cost of carry (Chan, 1992). However, because in efficient markets prices will adapt to the new information precisely and simultaneously, there will be a simultaneously perfect relationship between the price changes of spot index and index futures contract. In other words, spot index and the price of index futures contract must simultaneously react to the new information in the markets and there should be no lead-lag relationship between the price changes in two markets. Nevertheless, some market imperfections can lead to a faster reaction of one market to information compared to the other one, and therefore can lead to lead-lag relationship between markets (Stoll and Whaley, 1990; Chan, 1992). Due to some characteristics such as low transaction costs and high leverage effect, futures markets are expected to react faster to new information in the market and to lead spot markets. Therefore price changes in futures markets are expected to be followed by price changes in spot markets.

When it reaches the market, both markets will react to the new information. But, what's important is which market reacts faster to the new information. In other words, which market is informationally more efficient in the pricing process is what's important (Floros and Vougas, 2007).

The purpose of this study is to investigate, by using intra-day data (5 minutes), whether there is a lead-lag relationship in terms of both price and volatility between Turkish index spot markets and index futures markets. …

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