Price Formation in Spot and Futures Markets: Exchange Traded Funds vs. Index Futures

Posted: 6 Oct 2009

See all articles by Bernd Schlusche

Bernd Schlusche

Board of Governors of the Federal Reserve System

Date Written: October 5, 2009

Abstract

This paper reconsiders the process of price discovery in spot and futures markets. In our study, we examine the contribution of two derivative products of the German blue chip index DAX: Exchange traded funds and index futures. In order to eliminate noise caused by differences in the microstructure of the markets, we use transaction data only from electronic-trading markets. We apply a linear vector error correction model for our estimations and we use the common factor weights, first proposed by Schwarz and Szakmary (1994), to quantify the contribution of each market to the process of price discovery. Our results indicate that the futures market leads in the process of price discovery. Furthermore, we show that volatility, and not liquidity, as would be conjectured by the transaction-costs hypothesis, is the driving factor for relative price leadership between the two markets.

Keywords: Index Futures, Exchange Traded Funds, Vector Error Correction Model, Common Factor Weights

JEL Classification: G13, G14, G19

Suggested Citation

Schlusche, Bernd, Price Formation in Spot and Futures Markets: Exchange Traded Funds vs. Index Futures (October 5, 2009). https://doi.org/10.3905/JOD.2009.17.2.026, Available at SSRN: https://ssrn.com/abstract=1483405 or http://dx.doi.org/10.2139/ssrn.1483405

Bernd Schlusche (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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United States