Investigating the contributions to price discovery provided by individual stock futures, the authors focus on three of the largest and most actively traded securities on the NASDAQ OMX, which is the securities exchange in the Nordic market. A comparison of stock trading activities in the spot and futures markets supports the notion that prices are adjusted first in the futures market.
What’s Inside?
Using data from the successfully established market for futures contracts on individual stocks on the NASDAQ OMX, the securities exchange in the Nordic market, the authors analyze price discovery in futures for shares of Ericsson, Nokia, and Nordea. On the basis of the results of several econometric tests, they argue that a majority of the price adjustments in the forwards are carried through into the stock market. At the same time, the underlying shares are characterized by a great deal of liquidity-related adjustments to the order book that do not change prices in the futures market.
How Is This Research Useful to Practitioners?
Although futures for individual stocks have been established successfully on the OMX, the Australian Securities Exchange decided to end trading in individual stock futures several years ago. Whether such an additional securities market offering is attractive to investors depends largely on perceived benefits by market participants. The empirical evidence provided by the authors, namely the notion that trading in the futures market leads to trading in the underlying, assigns such a benefit to the futures market. They point to liquidity, transaction cost savings, and leverage as possible advantages for these transactions. On the basis of this evidence, they suggest that a broader offering of futures for individual securities would benefit traders.
The authors propose that futures trading on the OMX represents best practices. Trading in individual stock futures is organized as a crossing market, in which broker/dealers search for counterparties and derive the pricing from the limit order book.
How Did the Authors Conduct This Research?
The authors focus initially on all individual stock futures and their underlying stocks listed on the NASDAQ OMX Stockholm and Helsinki stock exchanges. Because of a lack of continuous intraday tick-by-tick data, the sample is restricted to three stocks. The data period covers the first seven months of 2007, which were not yet affected by the financial crisis. The forwards with the shortest time to expiration are combined to replicate a strategy of rolling over to the shortest and usually most liquid contract when a contract expires. The authors provide descriptive statistics and conduct a number of econometric tests. They initially observe that spreads are greater in the futures market than in the market for the underlying stocks and also point out that activity in the forward market is characterized by relatively large block trades.
Next, the authors conduct Granger causality tests and interpret the results as supportive of the hypothesis that forward pricing is important for share pricing. But it should be noted that there is considerable variation in their base case because it relates to hourly intervals. For Nokia, Granger causality is running in both directions. For Nordea, no Granger causality is present. Ericsson is the only one that has evidence of Granger causality running in the direction from the futures contract to the underlying. For the frequencies of one minute and one second that the authors report in the appendix, Granger causality is generally running in both directions.
The third set of tests focuses on an information share analysis, which is presented for frequencies of one hour and one minute. Although the futures appear to be dominant at the frequency of one minute, stocks lead at the hourly frequency in two of the three cases. The only exception is Nokia, for which the forwards dominate at both frequencies.
The final measure the authors use is the probability of informed trading. Although there is a very low probability of information-based trading in futures contracts, the ratio of informed trading is significant for the underlying shares. Based on volume data, the authors argue that the price discovery provided by futures contracts is related to liquidity.
Abstractor’s Viewpoint
Overall, the empirical case appears mixed. This result is probably not surprising given the sophistication and incentives of financial market participants and the theoretically expected absence of arbitrage opportunities. Further analysis of the lead–lag relationship between the two markets should focus on the economic significance of the observed effects, especially after accounting for bid–ask spreads.