Trading Costs and the Relative Rates of Price Discovery in Stock, Futures, and Option Markets

Abstract

In frictionless and rational markets, perfect substitutes must have the same price. In markets with trading costs, however, price differences may be as large as the costs of executing the arbitrage between markets. Moreover, if trading costs differ, trading activity will tend to be concentrated in the lowest-cost market. This study tests the differential trading cost hypothesis by examining the rate at which new information is incorporated in stock, index futures, and index option prices. The lead/lag return relations among markets are consistent with their relative trading costs. Prices in the index derivative markets appear to lead prices in the stock market. At the same time, index futures prices tend to lead index option prices, and the prices of index calls and index puts move together. The trading cost hypothesis reconciles the disparity found between the temporal relation in the stock index/index derivative markets versus the stock/stock option markets.

JEL Classification: G11, G12, G13, G14