Academic journal article Journal of Financial Management & Analysis

Do Different Futures Contracts in One Stock Exchange Have the Same Price Discovery Capability? Empirical Study of Taiwan Futures Exchange*

Academic journal article Journal of Financial Management & Analysis

Do Different Futures Contracts in One Stock Exchange Have the Same Price Discovery Capability? Empirical Study of Taiwan Futures Exchange*

Article excerpt

Introduction

Given the assumption of perfectly efficient capital markets, new information should be impounded into the relevant financial markets. Hence, there should be no any lead-lag relationship among the price movements in different markets. However, in the presence of market frictions, empirical findings suggest that some markets may reflect new information faster and, therefore, play a more important role in price discovery. The general conclusion concerning the interaction between index spot and futures markets is that the index futures market leads the index spot market and there is little evidence of a feedback relationship from the spot market to futures market. Some notable examples include Kawaller, et al.1, Stoll and Whaley2, Chan, et al.3, Chan4, and Ghosh5, among others. Recent works concerning international markets include studies by Abhyankar6 on the U.K. FTSE 100, Iihara, et al.7 on the Japanese NSA, and Roope and Zurbruegg8 on the Taiwan TAIEX.

Many articles suggest that the factors of transaction costs (e.g., Fleming, et al.9), liquidity or trading activity (e.g., Stephan and Whaley10), and short-sale constraint (e.g., Diamond and Verrecchia11) may affect the lead-lag relationship between financial markets. The fact that futures markets tend to have lower transaction costs and less short-sale regulation, providing higher liquidity and financial leverage, and reflect market-wide information supports the previous conclusion of price discovery. Subrahmanyam12 and Chan4 suggested that, because the futures market reflects market-wide information, futures prices should lead spot prices when more stocks move together (market-wide information).

Although the issue of price discovery has been extensively examined and analyzed, this paper is motivated by the following arguments. Most articles have investigated the relationship of return or volatility between spot and futures markets by examining one futures contract and concluding with the price transmission process. However, does every futures contract in an exchange have the same interaction pattern with its underlying asset? Can the results of one specific contract represent those of other contracts? Besides, although researchers have proposed many factors to explain why the futures market is likely to lead the spot market, there are still few empirical findings showing that the futures market does not dominate the spot market in price discovery (e.g., see Wahab and Lashgari13). It means that the characteristics of futures contracts may not always guarantee their lead capability.

There are only four index futures contracts available on the Taiwan Futures Exchange (TAIFEX). The major specifications for these index futures contracts will be shown in the following pages. Undoubtedly, those futures contracts share the same transaction costs, trading mechanisms, and short-selling constraints of the spot market. Previous studies concerning the Taiwanese futures market only investigate the price discovery of one major contract. However, should we expect these four systems have the same pattern of information transmission? By examining these four index futures and utilizing the error correction model (ECM), the information share developed by Gonzalo and Granger14, and generalized impulse response function (GIRF) proposed by Koop et al.15 and Pesaran and Shin16, this study will investigate the price discovery and information transmission for the entire Taiwan futures market, rather than a single futures contract. This investigation of information transmission is triggered by the fact of significantly different trading volumes of these four systems. If these four index futures consistently revealed information faster than their respective underlying indices, we may confidently assert that, in Taiwan financial market, futures contract can always play the major role in the process of price discovery. If not, that futures dominates spot in Taiwan market should be concluded cautiously. …

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