Lakshmi-0483-Price Discovery in Cash& Futures Market

Price discovery in Cash and Futures Market
A RESEARCH PROJECT
On
“Price Discovery in Cash and Future markets”

Submitted in partial fulfillment of the requirement for MBA
Degree of Bangalore University
BY
Lakshmi S N
Registration Number
04XQCM6046
Under the guidance of
Dr. N.S.Mallvalli
M.P.Birla Institute of Management

Associate Bharatiya Vidya Bhavan
Bangalore-560001
2004-2006
M P Birla Institute Of Management 1

DECLARATION
I hereby declare that the research project titled “Price discovery in cash and futures
markets ” is prepared under the guidance of Dr.N.S. Mallavalli in partial
fulfillment of MBA degree of Bangalore University, and is my original work.
This project does not form a part of any report submitted for degree or diploma
under Bangalore University or any other university.
Date :
Place: Bangalore Lakshmi S N

PRINCIPAL’S CERTIFICATE
This is to certify that Ms. Lakshmi S N, bearing Registration No: 04XQCM6046
has done a research project on “Price Discovery in Cash and Futures Markets”
under the guidance of Dr. N.S.Mallavalli, M P Birla Institute of Management,
Bangalore. This has not formed a basis for the award of any degree/diploma for
any other university.
Place: Bangalore Dr.N.S.MALLAVALLI
Date: MPBIM, Bangalore

GUIDE’S CERTIFICATE
I hereby declare that the research work embodied in this dissertation entitled
“Price discovery in Cash and Futures Markets” has been undertaken and
completed by Miss. Lakshmi .S. N under my guidance and supervision.
I also certify that she has fulfilled all the requirements under the covenant
governing the submission of dissertation to the Bangalore University for the award
of MBA Degree.
Place: Bangalore Dr. N S MALLVALLI

Date: MPBIM, Bangalore
ACKNOWLEDGEMENT
I am thankful to Dr.N.S.Malavalli, Principal, M.P.Birla institute of management,

Bangalore, who has given his valuable support during my project.
I am extremely thankful to Prof. Dr.N.S.Malavalli , M.P.Birla institute of

Management, Bangalore, who has guided me to do this project by giving valuable
suggestions and advice.
My special thanks to Dr. T.V.N Rao and Prof. Santhanam, who provided me the
timely advice and and has helped remarkably to complete the project.
Special thanks to my friend Megha N Bias who made this report reality.
Finally, I express my sincere gratitude to all my friends and well wishers who
helped me to do this project.
LAKSHMI S N

TABLE OF CONTENTS
CHAPTERS PARTICULARS PAGE NO.
ABSTARCT
1. INTRODUCTION
1.1 Introduction and Background of the study 1-7
2. REVIEW OF LITERATURE
Theoretical Framework 8 -15
Past studies 16 - 20
3. RESEARCH METHODOLOGY
3.1 Hypothesis Statements 21
3.2 Data sampling details 22 - 23
3.2 Statistical Models 24 - 29
4. DATA ANALYSIS AND INTERPRETATION
Empirical Results 30 - 38
5. INFERENCES AND CONCLUSIONS 39 - 40
BIBLIOGRAPHY 41
ANNEXURES 42 - 58

ABSTRACT
One of the important function of Futures market is Price discovery. Futures markets
provide a mechanism through which information about current and futures Spot prices can be
assimilated and disseminated to all participants in the economy. The ability of future markets to
provide information about price is a central theme for the existence of these markets.
The present study has been done to examine whether the futures market is performing its
primary role of price discovery. The main objectives of the study is to examine whether there
exists any long run equilibrium relationship between spot market and future market and to
identify the lead – lag relationship between these markets.
The daily NSE closing prices of Nifty Spot Index and Nifty Index Futures of near month
contracts from 12th June 2000 to 31st Mar 2006 have been taken for the study purpose. After
obtaining the statonarity of the series by conducting Augmented Dickey Fuller Test, Granger’s
Co integration Test and Johansen Co integration Test have been conducted on the Nifty Spot and
Nifty futures. The empirical results indicate that there exists long run equilibrium between these
two markets. Further Granger’s Causality Test results indicate that there exists lead – lag
relationship between these Spot market and Future market. It also shows that there is much
feedback from Futures market to Spot market in impounding information in its prices
Finally, from overall empirical results conclude that Futures markets are more efficient in
discovering the Future spot price.


) INTRODUCTION
One of the important functions of the futures market is price discovery and hedging. Futures
market provides a mechanism through which information about current and future spot can be
assimilated and disseminated to all participants in the economy. The futures trading in India
started with the introduction of index futures on NSE and BSE in June 2000
Futures markets have 2 important functions in the economy – providing hedge facilities and price
discovery. The ability of futures markets to provide information about an optimum allocation of
resources in an economy, prices must accurately reflect relative production costs and relative
consumption utilities. Futures markets, by providing a mechanism through which information
about current and futures spot prices can be assimilated and disseminated to all participants in
the economy, help to achieve this goal
All these prices are the result of open and competitive trading and reflect the underlying supply
and demand for a financial asset or a good, both in the present and at various times in the future.
Most specifically, in the case of future delivery, future prices reflect current expectations about
what the supply and demand for a commodity or a financial asset are likely to be at different
times in future. As such future prices discover expected spot prices. The equilibrium spot prices
that are expected to prevail at various times in the future.
In India, derivatives were introduced as a part of financial market reforms to hedge price risk
which started in 1990’s. These reforms were aimed at enhancing competition, transparency and
efficiency in the Indian financial market. This was initiated by the Govt. Of India through
L.C.Gupta committee report. The L.C.Gupta committee on derivatives had recommended in
1997 its introduction in a phased manner. Accordingly stock index futures were introduced on
BSE and NSE in the first. BSE was the first stock exchange in the country, which commenced
trading in index futures based on the BSE Sensex on June 9, 2000. Immediately, there after, on
June 12, 2000, NSE introduced its trading based on S&P CNX NIFTY. Subsequently, later on,
other products like stock futures on individual securities were introduced in November 2001.

This was followed by approval of trading in index options based on these two indices and
options on individual securities.
Nifty futures traded on NSE are based on S&P Nifty index. At any point of time, contracts with
one month, two months and three months to expiry are available for trading. These contracts
expire on last Thursday of the expiry month and incase of the last Thursday being holiday, the
contracts expire on previous trading day and have a maximum of the expiry of near month
contract. Nifty futures are presently cash settled. The turnover in derivatives segment has
witnessed significant growth in the last 5 years.
The relationship between stock index spot and futures markets is still attracting the attention of
academics, practitioners and regulators due to both the considerable volume of trading in these
contracts and their role during periods of turbulence in financial markets. An important aspect of
this relationship is the nature of the lead-lag relationship in the returns between equivalent assets
traded in different markets or the predictive power of price movements in one market for those in
the other market.
One of the economic functions of futures contracts is price discovery. Price discovery refers to
the use of futures prices for pricing cash market transactions and its significance depends upon
the above mentioned, close relationship between the prices of futures contracts and the
underlying assets. The essence of the price discovery function of futures markets hinges on
whether new information is reflected first in changes of futures prices or in changes of cash
prices.
In other words, price discovery means whether price changes in futures markets lead price
changes in cash markets more often than the reverse. If that is the case, there exists a lead-lag
relationship between the two markets. Therefore, the futures prices may serve as the market’s
expectation of a subsequent delivery period cash price. The share of price discovery originating
in the futures markets has important implications for hedgers and arbitrageurs who use these
markets.

The introduction of stock index futures cause an increase in volatility in the short run while there
is no significant change in volatility in the long-run (Edwards 1988).This is because futures
markets result in uninformed (irrational) speculators trading in both futures and cash markets,
shocking prices in search of short-term gains. Hodgson and Nicholls (1991) quote that increased
market volatility may increase real interest rates and the cost of capital, leading to a reduction in
the value of investments and loss of confidence in the market. In turn, this can lead to a flow of
capital away from equity markets. Secondly, with increased volatility, regulatory bodies may
interfere in markets to enact further regulations. While these regulations are certainly costly and
may or may not reduce stock price volatility. However, another view is that derivative markets
reduce spot volatility; by providing low cost-contingent strategies, enabling investors to
minimize portfolio risk by transferring speculators from spot markets to futures markets. The low
margins, low transaction costs and the standardized contracts and trading conditions attract risk-
taking speculators to futures. Hence, futures have a stabilizing influence as it adds more
informed traders to the cash market, making it more liquid and, therefore, less volatile. It is seen
that increased spot volatility from futures markets may not be undesirable if induced by objective
new information. In general, the quicker and more accurate prices reflect new information, the
more efficient should be the allocation of resources.

) BACKGROUND OF THE STUDY
Future contract is an agreement to buy and sell an asset at a future time for a certain price which
is traded in an organized exchange and the contract’s term are standardized by orgainse
exchange. The institutional environment includes a clearing house to guarantee to all trades and
margin system design to protest the financial integrity of the market place. This system allows
the futures market two social benefits: prices discovery and risk transferring through hedging.
Price discovery reveals how fast one markets reflect new information relative to the other, and
how well the two markets are linked. Risk management illustrates how the price risk of a certain
position in the cash market may be reduced through futures market by hedgers. The dual roles of
price discovery and risk transfer provide benefits that cannot be offered in the cash market alone.
The futures markets serve an important function of price discovery. The following concepts help
to identify the theoretical frame work.
• CURENT CASH PRICE
Assets are commonly traded in cash markets by a network of dealers. In which each dealer gives
his own prices. This price often differs from one another either because dealers operate
indifferent geographical markets or customers are not aware of price differences that exist. To
get the lowest price, a buyer need a conduct time consuming and costly search I the market.
Futures market provides highly visible prices against which the current cash prices of dealers can
be compared. if prices of futures contract for immediate or near term delivery differ from
dealer’s cash prices, traders can arbitrage this difference. All cash prices will therefore reflect
accurately the supply and demand equilibrium brought by futures market.

• EXPECTED CASH PRICE
Since futures contracts are traded for delivery at various points of time future, they reflect current
market expectation about the cash price in future. This is also reflects the market expectations of
the demand and supply of an asset at a particular point of time of the future. If futures prices are
considerably higher than the current cash prices, it reflects the market expectation of relative
shortage of asset in the future, whereas lowest future prices indicate relative surplus of the asset
in the future. Though futures trading, information about the expectations of all the market
participants, commercial hedgers and speculators about the demand and supply for an asset in the
future month are assimilated to produce a single futures price for that month. Futures a market
help to smoother the supply and demand of an asset over a period of time and help to avoid
economic dislocation by the discovery of expected cash prices.
The advent of stock index futures and options has profoundly changed the nature of trading on
stock exchanges. The concern over how trading in futures contracts affects the spot market for
underlying assets has been an interesting subject for investors, market makers, academicians,
exchanges and regulators alike.
These markets offer investors flexibility in altering the composition of their portfolios and in
timing their transactions. Futures markets also provide opportunities to hedge the risks involved
with holding diversified equity portfolios. As a consequence, significant portion of cash market
equity transactions are tied to futures and options market activity. In the Indian context,
derivatives were mainly introduced with a view to curb the increasing volatility of the asset
prices in financial markets; bring about sophisticated risk management tools leading to higher
returns by reducing risk and transaction costs as compared to individual financial assets.
However, it is yet to be known if the introduction of stock index futures has served the purpose
claimed by the regulators. The launch of derivative products has significantly altered the
movement of the share prices in the spot market. The spot and futures market prices are linked
by arbitrage, i.e., participants liquidating positions in one market and taking comparable

positions at better prices in another market, or choosing to acquire positions in the market with
the most favorable prices. If, for example, the observed futures price is above (below) the
theoretical futures price, arbitrageurs sell (buy) futures and buy (sell) the underlying security,
driving down (up) the price of the futures and driving up (down) the prices of security. This
raises important questions about the effect that index derivatives have on volatility of the spot
market. While there is still disagreement as to whether futures trading increases or decreases the
volatility of spot prices, the question is still an empirical one. However, if one market reacts
faster to information, and the other market is slow to react, a lead-lag relation is observed. The
lead-lag relation between price movements of stock index futures and the underlying cash market
illustrates how fast one market reflects new information relative to the other, and how well the
two markets are linked. Hence, this study attempts to examine the lead – lag relationship
between the futures and the underlying spot market.
) PROBLEM STATEMENT
It is well known that prices of related securities like prices in spot and futures markets cannot
diverge without bound because they are linked by an arbitrage relationship. The link between this
arbitrage relationship (and the associated cost of carry model) may diverse due to short term
disequilibrium. Therefore the existence of a long run co integration relationship between the spot
and futures prices is the problem to be studied with the Granger’s Co integration test and Error
Correction Model.
) OBJECTIVES OF THE STUDY

¾ To know whether futures trading in India is performing its primary role of price
discovery
¾ To know whether there exists long term equilibrium between futures and spot
prices along with short term equilibrium dynamics.
¾ To know whether there exists lead- lag relationship between spot and futures
market.

) SCOPE OF THE STUDY
The research examines the effectiveness of stock index futures by analyzing the dynamic
interactions and causal relationship between speculative type activity and spot market volatility.
Evidence for bi-directional information flow between speculative activity and volatility are
examined between S&P CNX nifty and S&P CNX Nifty Futures Market. It appears that
investors speculate in the futures market, in particular when faced with volatility in the cash
market. The fluctuations as a result of speculative activity are decreasing over a period of time,
possibly due to the hedging activities taking place in the market. The dynamic interactions
between speculative activity and spot volatility show that index futures are having a stabilizing
effect on underlying spot market.
) LIMITATIONS OF THE STUDY
• The study is limited only to S&P CNX NIFTY and S&P CNX NIFTY Futures.
The study is not done on stocks and stocks futures. Therefore the conclusions
are based on S&P CNX NIFTY and S&P CNX NIFTY Futures.
• The study is limited to near month contract. The Mid month contract and Far month
contracts have not been considered.


) THEORITICAL BACKGROUND
) INDEX
An index is a number used to represent the changes in a set of values between a base time period
and the current time. A stock index represents change in the value of a set of stocks which
constitute the index over a base year
) INDEX FUTURE
An index future is a derivative whose value is dependant on the value of the underlying asset (eg.
BSE Sensex, S&P CNX NIFTY). While trading on index futures, an investor is basically buying
and selling the basket of securities comprising an index in their relative weights. Unlike
commodity and other futures contracts, Index Future contracts are settled in cash.
) FUTURES CONTRACT
A futures contract is a standardized, transferable, exchange-traded contract that requires delivery

of a commodity, bond, currency, or stock index, at a specified price, on a specified future date.
Generally, the delivery does not occur; instead, before the contract expires, the holder usually
"squares their position" by paying or receiving the difference between the current market price of
the underlying asset and the price stipulated in the contract.
Unlike options, futures contracts convey an obligation to buy. The risk to the holder is unlimited.
Because the payoff pattern is symmetrical, the risk to the seller is unlimited as well. Money lost
and gained by each party on a futures contract are equal and opposite. In other words, a future
trading is a zero-sum proposition.
Futures contracts are forward contracts, meaning they represent a pledge to make a certain

transaction at a future date. The exchange of assets occurs on the date specified in the contract.
Futures are distinguished from generic forward contracts in that they contain standardized terms,
trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by
clearinghouses. Also, in order to insure that payment will occur, futures have a margin
requirement that must be settled daily. Finally, by making an offsetting trade, taking delivery of
goods, or arranging for an exchange of goods, futures contracts can be closed.
Trading in futures is regulated by the Securities & Exchange Board of India (SEBI). SEBI exists
to guard against traders controlling the market in an illegal or unethical manner, and to prevent
fraud in the futures market.
) ADVANTAGES OF FUTURES TRADING
There are many inherent advantages of trading futures over other investment alternatives such as
savings accounts, stocks, bonds, options, real estate and collectibles.
1. HIGH LEVERAGE.
The primary attraction, of course, is the potential for large profits in a short period of time. The
reason that futures trading can be so profitable is the high leverage. To ‘own’ a futures contract
an investor only has to put up a small fraction of the value of the contract (usually around 10-
20%) as ‘margin’. In other words, the investor can trade a much larger amount of the security
than if he bought it outright, so if he has predicted the market movement correctly, his profits
will be multiplied (ten-fold on a 10% deposit). This is an excellent return compared to buying
and taking physical delivery in stocks.

2. PROFIT IN BOTH BULL & BEAR MARKETS
In futures trading, it is as easy to sell (also referred to as going short) as it is to buy (also referred
to as going long). By choosing correctly, you can make money whether prices go up or down.
Therefore, trading in the futures markets offers the opportunity to profit from any potential
economic scenario. Regardless of whether we have inflation or deflation, boom or depression,
hurricanes, droughts, famines or freezes, there is always the potential for profit making
opportunities.
3. LOWER TRANSACTION COST
Another advantage of futures trading is much lower relative commissions. Your commission for
trading a futures contract is one tenth of a percent (0.10-0.20%). Commissions on individual
stocks are typically as much as one percent for both buying and selling.
4. HIGH LIQUIDITY.
Most futures markets are very liquid, i.e. there are huge amounts of contracts traded every day.
This ensures that market orders can be placed very quickly as there are always buyers and sellers
for most contracts.
) S & P CNX NIFTY
S&P CNX Nifty is a well diversified 50 stock index accounting for 25 sectors of the economy. It
is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives
and index funds.
S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which
is a joint venture between NSE and CRISIL.

The average total traded value for the last six months of all Nifty stocks is approximately 49.8%
of the traded value of all stocks on the NSE
• Nifty stocks represent about 56.5% of the total market capitalization as on March
31, 2006.
• Impact cost of the S&P CNX Nifty for a portfolio size of Rs.5 million is 0.07%
• S&P CNX Nifty is professionally maintained and is ideal for derivatives trading
) S&P CNX NIFTY FUTURES
A futures contract is a forward contract, which is traded on an Exchange. NSE commenced

trading in index futures on June 12, 2000. The index futures contracts are based on the popular
market benchmark S&P CNX NIFTY index.
NSE defines the characteristics of the futures contract such as the underlying index, market lot,
and the maturity date of the contract. The futures contracts are available for trading from
introduction to the expiry date.
) CONTRACT SPECIFICATIONS
The security descriptor for the S&P CNX Nifty futures contracts is:
Market type: N
Instrument Type: FUTIDX
Underlying: NIFTY
Expiry date: Date of contract expiry
Instrument type represents the instrument i.e. Futures on Index.

Underlying symbol denotes the underlying index which is S&P CNX Nifty

Expiry date identifies the date of expiry of the contract
) TRADING CYCLE
S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - the near month
(one), the next month (two) and the far month (three). A new contract is introduced on the
trading day following the expiry of the near month contract. The new contract will be introduced
for three month duration. This way, at any point in time, there will be 3 contracts available for
trading in the market i.e., one near month, one mid month and one far month duration
respectively.
) EXPIRYDAY
S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If the last
Thursday is a trading holiday, the contracts expire on the previous trading day.
) FUTURES PRICE FORMATION
There are two views in futures literature regarding price formation process of futures prices. In
the first, the inter-temporal relationship between cash and future prices of futures is explained by
cost of carry model.
The theory of inter-temporal relationship between cash and futures prices can be explained with
the cost of carry model. This is given as
Ft = St e r t
r = holding costs
t = time till expiration.
If F > St e r t or F < St e r t then futures price is away from its fair value and arbitrage opportunities

exist there. The relationship between the cash market and futures market are thought of as being
maintained by professional arbitragers who employ computerized trading systems to capitalize
on deviations of stock index futures prices from perceived fair values or whenever parity
represented by equation (1) is violated. If actual futures price exceed their perceived fundamental
value, the futures contract is overvalued. In this situation, arbitragers simultaneously take
positions in the underlying market and futures market, and hence lock in a secure payoff. When
the futures contract is overvalued arbitragers sell futures contract and buy stocks in the
underlying market while on the other hand, an undervalued futures contract triggers a short
arbitrage position where arbitragers buy futures and sell stocks simultaneously in both the
markets.
If F0 = E (St) , the futures price will drift up or down only if the market changes its views about
the expected future spot price. Over a long period of time, it assumed the market revises its
expectations about futures spot prices upward as often as it does so downward. It follows that
when F0 = E (St), the average profit from holding futures contracts over a long period of time
should be zero. The F0 < E (St) situation corresponds to the positive systematic risk situation.
Because the futures price and the spot price must be equal at maturity of the futures contract, this
implies that that a futures price should , on average , drift up and a trader should over a long
period of time make positive profits from consistently holding futures positions. Similarly , the
F0 > E(ST) situation implies that a trader should over a long period of time make positive profits
from consistently holding short futures positions.
The second view splits the futures price into an expected risk premium and a forecast of a future
spot price. The basis can be expressed as a sum of an expected premium and an expected change
in the spot price.
FtT – St = Et (p(t,T)+ Et (ST – St)
Here the expected premium Et = (P (t, T) is defined as the bias of future price as a forecast of the
future spot price.

Et [p(t,T)] = FtT - Et[ST]
Fama and French argue that the theory of holding cost, equation(1) and equation(2) are
alternative but not competitive views of the basis, and the variation in expected change in the
spot price in equation(2) translates into variation in the interest rate and stable relationship
between spot and futures prices. In addition, for the future price to be an unbiased predictor of
eventual spot price premium must be zero, the future price should lead spot price.
The implication of the cost of carry model is that in perfectly efficient and continuous spot and
futures market, price adjustments are instantaneous. The observed relationship between price
changes in the two markets will be noisy due to market imperfections and because price
observations from the two markets are not simultaneous. Therefore the normal relationship
between stock index and stock index futures would be bounded by a lower and upper bound of
no arbitrage trading band. This no arbitrage trading band is determined by market imperfections.
Besides this, a lead-lag relation between price changes in the two markets is very likely, if there
are economic incentives for traders to use one market over the other.
) DEVIATIONS OF FUTURES PRICES FROM THEIR FAIR VALUES
The trading strategies most closely identified with the term "stock index arbitrage" are those that
profit from deviations of a stock index futures price from its fair value. A short NIFTY futures
contract effectively converts an investment in NIFTY portfolio into a short term loan at a risk-
free rate of interest. Similarly, a long NIFTY futures contract converts a short position in the
NIFTY portfolio into a short-term debt at a risk-free rate of interest.
This rate of interest is not explicitly quoted but is a synthetic rate derived from the relationship
between the futures and cash index prices. An investor who buys the NIFTY portfolio spot and
simultaneously sells it forward with a short NIFTY futures position is nevertheless "lending" at
this implied rate, just as he would lend at money market rate. Similarly, an investor who shorts
the NIFTY portfolio and simultaneously buys the portfolio forward with long NIFTY futures

position is "borrowing" at the rate of interest implied by the futures price "implied futures rate".
Since an investor can lend or borrow at the implied futures rate, a profitable arbitrage
opportunity arises whenever the implied futures rate differs from the money market rate at which
the investor can lend or borrow. If the implied futures rate is greater than an investor's borrowing
rate, the futures price is deemed "rich", i.e., it is greater than its fair value. To profit from the
mispriced futures, the investor borrows at the money market rate and lends at the higher implied
futures rate.
Conversely, the futures price is deemed "cheap", i.e., smaller than its fair value, if the implied
futures rate of interest is smaller than the investor's lending rate. In this case, the investor
borrows at the implied futures rate and lends at the higher money market rate.

) PAST STUDIES
The relationship between spot and futures market has been the focus of much literature for some
time. This include the fact that futures markets tend to have less trading constraints than the cash
markets, leading to future markets being more informationally efficient as the marginal cost from
trading will be less than in the cash markets. This is further compounded by the fact that futures
market tend to have lower transaction cost and higher liquidity.
There is wide body of research which clearly indicates futures market lead spot market and
suggest that this provides evidence of futures markets are acting as a vehicle for price discovery
within the corresponding spot markets…
Pascal Alphonse *1 studied (2000) the information linkage between the Nifty Index and Nifty
Futures and its near-month index futures contract and the role (lead or lag) that the futures
market plays using daily closing futures and cash prices.
The study is concerned with the aggregation of information in the French Stock Index Cash and
Futures Markets. The Results indicate that deviations from the equilibrium relationship linking
cash and futures prices originate from information arrivals in the futures market and theta at least
95 % of their price discovery is achieved in this market.
Arbitrage relationship (cost of carry pricing model) and co integration relationship between the
spot and futures prices has been extensively used. Literature suggests inference concerning spot
and future price dynamics should be based on “ERROR CORRECTION MODEL”. It suggests
that the spot and futures market should share a “Common Stochastic Trend Model” inspired from
HASBROUCK (1995) . Inference concerning error connection mechanism may be obtained from
JOHANSEN (1988) ECM MODEL .Inference concerning the common (unobserved) efficient
price may be obtained from the vector moving average.
*1 indicates Reference article no 1 ---- Pascal Alphonse----See Bibliography

Ash Narayan Sah and Anil Kumar *2 (2006) studied whether the derivatives trading are
performing its primary role of price discovery. The main objectives of the study were to know to
know whether there exists feedback mechanism between NIFTY spot and NIFTY futures. Daily
NSE data pertaining to stock index futures taken from JUNE 12th 2000 to Mar 31st 2005. Stoll
and Whaley 1990, examined intra day price changes from S&P 500 and MM stock index and
futures contracts for serial correlation via-ARMA (p,q) process The Co integration approach and
an ECM using the ENGLE-GRANGER methodology is applied to capture both the long run and
short run dynamics of spot and futures prices. Testing of stationary of series is performed by
using augmented Dickey Fuller Test.
Results indicate that there exists a long run relationship between NIFTY spot and futures price.
Presence of co integration between NIFTY spot and futures indicates market is not efficient. One
can combine information of NIFTY spot and futures prices to predict futures NIFTY spot price.
ECM leads to the conclusion that there exists feedback between NIFTY spot and NIFTY futures.
Results also show spot market leads the futures market and price discovery takes place in both
the markets.
Dimitris F. Keniurgois3 (Oct2004) examined the relationship between price movements of
FTSE/ASE 20, 3 months index and the underlying cash market in Athens Stock Exchange.
FTSE/ASE 20 futures market, as the first organized Greek derivatives market, established in Aug
1999. Co integration tests are used and an Error Correction Model is developed in order to
examine the relationship between price movements of FTSE/ASE 20, 3 months index and the
underlying cash market in Athens Stock Exchange. the results show the presence of a bie
directional causality between Stock index spot and futures market , indicting that the newly
established ADEX can provide futures contracts that serve as a focal point of information
assimilation and fulfill their price discovery. The Co integration and ECM is used to examine the
co movements between the series. ADF test is done to know the stationarity of the series.
*2 indicates Reference article no 2 ---- Ash Narayan Sah and Anil Kumar----See Annexure
*3 indicates Reference article no 3 ---- Dimitris F. Keniurgois-----See Annexure

Daily data are used during the period from Aug 1999 to June 2002. The logs of the spot and
futures prices are used. Futures prices are of nearby contracts. The results Engle – Granger and
Johansen methods of co integration indicate that the presence of a bi directional causality
between the spot index and futures index markets, thus informational linkage between them. This
empirical evidence suggests that the newly established ADEX market provide futures contracts
that can be used as vehicles for price discovery. The temporal relationship between Chicago Corn
and Soyaben cash prices, nearby futures prices and interest rates is examined using daily 1980 –
1989 data. Johansen Co integration tests suggest joint movement of the 3 series over the data
period considered.
Hector. O. Zapata and T. Randall Fortenbery *4 (1995) in their study examined the relationship
between Chicago corn, Soyaben cash prices, nearby future prices. The Co integration approach
of Granger is used to test the relationship between cash, futures and interest rates. Error
Correction Model used to overcome the short term disequilibrium. Daily closing prices for corn
and Soyabean futures contract from 1980 – 89, daily Chicago and Soyabean cash prices for the
period 1980 – 89 and 90 day US T- bill rates for the same period. Futures contracts observed are
the one closest to maturity.
The empirical tests show that cash, futures and interest rates prices are non stationary Of order
one. This suggest that Chicago cash prices and nearby futures prices behave a stochastic trend
variables during all 10 years and 90 day T bill rate has stochastic trend during most years.
Results support the hypothesis that futures market provide a price discovery function and suggest
that cash market are not merely a derivative market of the futures. The findings of co integration
over the aggregate data period suggest that there is long run causation either from the futures to
the cash market or vice versa. The relationship between the stock markets of the developed
countries has been examined extensively in the literature. The study examines the
interdependence of the 3 major stock markets in South Asia.

Golaka .C. Nath and Sunil Varma *5 (June 2003) in their study have taken Daily stock market
data from Jan 19994 to Nov 2002. Sock market indices of India (NSE NIFTY), Singapore (STI)
and (TAIEX) is been examined for their study purpose. Dynamic linkage is examined using
Granger’s Causality Concept (1969, 1988). ADF is used to test the stationarity of the series.
ECM was used since data series ware nonstationary. Johansen Methodology is been used to
overcome the many deficiencies brought forward by a number of researchers The research has
been done on the 3 important capital markets in Asian region and during the period from 1994 to
2002. The literatures suggest that existence of significance interactions between the various
equity markets, the empirical results shows that generally returns in these markets are not
interrelated and there is no long run equilibrium. Therefore the results suggests that international
investors can achieve long term gains by investing in the stock market as the market under study
have been generally independent.
Stoll and Whaley (1990) considered these two latter factors play vital role in explaining why
future markets tend to exhibit price leadership effects over stock markets. In their study Stoll and
Whaley examined intra-day price changes from S&P 500 and MM Stock index and Futures
contracts for serial correlation via and ARMA (p,q) process. They found strong evidence of
futures markets leading stock indices.
Further Research by Antony and Miller(1988) have suggested investors prefer trading in the
derivatives markets rather that the stock markets because of market frictions such as transaction
costs and capital requirements. Evidence of future price leadership over spot prices is also not
confined to research on the US markets. By examining the lead-lag relationship between stock
index prices and index futures contracts within an ARMA (p, q) frame work, noted future’s price
leadership for the German DAX index futures contract. Similar results were also obtained by
Shyy, Vijayaraghavan and Scott-quinn for the French CAC index futures contract. This shows
whether there are lead-lag relationships between spot and futures market.

In India, Thenmozi and Raju (2002) and Karnade (2003) made earliest studies on the lead-lag
and price discovery of futures market in India. This tries to unravel the dynamic relationship
between the futures and spot market in India and will provide some early empirical evidence in
this regard.
The past studies have done to test the price transmission process have used mainly the regression
analysis. However, if price series are not stationary, a phenomenon typical in financial markets,
then standard statistical tests of parameter restrictions is not reliable (Elam and Dixon, 1988).
Thus, for overcoming the problems of non-stationary price series and due to the fact that price
discovery deals with short-run and long-run departures from a presumed equilibrium relation, the
introduction of co integration analysis with error correction models is fortuitous.


) HYPOTHESIS STATEMENTS
) COINTEGARTION TEST
HYPOTHESIS STATEMENT 1
Ho: There is no significant co integration between spot and futures markets

H1: There is significant co integration between spot and futures market
) CAUSALITY TESTS
Ho: Future markets significantly do not lead the spot market

H1: Future markets significantly lead the spot market
Ho: spot market significantly does not lead the futures market
H1: spot markets significantly lead the futures market

) DATA COLLECTION
The data employed in this study comprises of 1460 daily observations on the NIFTY stock index
and stock index Futures contracts (12-03-2000 to 31-03-2006)
Closing prices of spot indices are obtained from the YAHOOFINANCE website and closing
prices of futures contracts are obtained from official website NSEINDIA (www.nseindia.com).
The NIFTY index comprises of 50 Indian companies, quoted on the NATIONAL STOCK
EXCHANGE (NSE), with the largest market capitalization (blue chips) in the Indian equity
market.
Futures contracts are taken which are quoted on the NATIONAL COMMODITY AND
DERIVATIVE EXCHANGE.
NIFTY futures contracts have a maximum of 3-month trading cycle - the near month (one), the
next month (two) and the far month (three).
We have confined the analysis to the near contract because of high trading volume and greater
liquidity in the F & O market and the preliminary research showed that there was not very
much difference between the closing prices of the nearest and second contract.
Daily data are preferred in this study is confined to 6 years which is helpful to get the better
results.

) DATA TYPE
The present research makes use of secondary data available in the NSEINDIA website
pertaining to the daily closing prices data of Nifty index and Nifty index futures.
) DATA SAMPLE
Daily NSE data pertaining to NIFTY index futures and stock futures.
) PERIOD OF SAMPLE
Daily observation from JUNE12th 2000 to March 31st 2006
) STATISTICAL MODELS APPLIED
• Augmented Dickey Fuller test to test the stationary of the series.

• Granger’s co integration approach and Johansen co integration test for co integration
between the series.
• Granger’s Causality test.
) STATISTICAL SOFTTWARE PACKAGES USED
• E views
This software has been used to conduct the Augmented Dickey Fuller Unit root Test,
Johansen Co integration Test and Granger’s Causality Test
• SPSS
Regression coefficients for Granger’s co integration test are obtained by using this
Software

) METHODOLOGY
In this study, and Johansen cointegration Approach and Engle-Granger methodology is applied to
capture both the long run and the short run dynamics of stock returns and inflation rates. Before
doing co-integration analysis, it is necessary to test whether the time series are stationary at
levels by running Augmented Dickey fuller (ADF) test on the series. Because most time series
are non stationary in levels, and the original data need to be transformed to obtain stationary
series. And then the granger causality test is done to test the causal relationship between stock
returns and inflation.
) STATIONARITY
According to Engle and Granger, a time series is said to be stationary if displacement over time
does not alter the characteristics of a series in a sense that probability distribution remains
constant over time. In other words, the mean, variance and co-variance of the series should be
constant over time. The degree of co-integration is closely related with stationary.
The empirical works based on time series data assumes that the underlying time series is
stationary. In regressing a time series variable on another time series variables, one often obtains
a very high R2 (residuals) even though there is no meaningful relationship between the two
variables. This situation exemplifies the problem of spurious or nonsense regression, which
arises when data is non stationary.
A series is said to be integrated of order one [I (1)] if it has to be differentiated once before
becoming stationary. Similarly, a series is of order two [I(2)] if it has to be differentiated twice
before becoming stationary.

) THEORY OF STATIONARITY
Following are different ways of examining about whether a time series variable Xt is stationary
or has a unit root:
) In the AR (1) model, if ρ =1, then X has a unit root. If ρ |< 1 then X is stationary.
) If X has a unit root, and then its autocorrelations will be near one and will not drop
much as a lag length increases.
) If X has a unit root, and then it will have a long memory. Stationary time series do not
have long memory.
) If X has a unit root then the series will exhibit trend behavior.
If X has a unit root, then ΔX will be stationary. For this reason, series with unit root are often
referred to as difference stationary series
This means that if the appropriate order of the AR process is lag2 rather than lag1, the term ΔYt-
1 should be added to the regression model. A test of whether there is a unit root can be carried
out in the same way as for the DF test, with the test statistics provided by the ‘t’ statistics of the ρ
coefficient. If ρ = 0 then there is a unit root. The same reasoning can be extended for a generic
AR (p) process.

) TESTING STATIONARITY BY UNIT ROOT TEST OF DICKEY FULLER
) HYPOTHESIS STATEMENT
H0: Series has Unit root : Non Stationary

H1: Series does not have Unit root : Stationary
Dickey Fuller test involve estimating regression equation and carrying out the hypothesis test.
The AR (1) process is….
Yt = C + ρYt-1+ εt
Where c and …..are parameters and is to be white noise. If -1 < ρ < 1, then Y is stationary series.
While if ρ = 1, y is non stationary series. Therefore, the hypothesis of a stationary series is
involves whether the absolute value of b is strictly less than one. The test is carried out by
estimating an equation with Yt-1 subtracted from both sides of the equation.
Δyt = C + γt-1 + εt
Where …… and the null and alternative hypotheses are
Ho: = 0 …..Non Stationary

H1: = 0 …..Stationary
The usual t-statistic under the null hypothesis of a unit root does not have the conventional t-
distribution. Dickey and fuller (1979) showed that the distribution under the null hypothesis is
nonstandard and simulated the critical values for selected sample sizes. More recently,
Mackinnon (19991) has implemented a much larger set of simulations than those tabulated by
Dickey and Fuller.

) UNIT ROOT TEST BY AUGMENETD DICKEY FULLER TEST
The simple Unit root test is valid only if the series as an AR (1) Process. If the series is correlated
at high order lags, the assumption of white noise disturbances is violated. The ADF controls for
high- order correlation by adding lagged difference terms of the dependent variable to the right-
hand side of the regression
Δyt = C + γt-1 + δ1Δ yt-1 + δ2Δ y t-2 + …..+ δpΔ y t-p + εt
This augmented specification is then tested
H0: = 0 Non Stationary

H1: = 0 Stationary
In general, the procedure start with whether the variables X and Y in its level form is stationary.
If the hypothesis is rejected, then the series is transformed into first difference of the variable and
tested for stationarity. If first difference series is stationary, this implies that X and Y are I(1).
) GRANGERS CO-INTEGRATION TEST
Granger introduced the concept of co-integration when he wrote that two variables may move
together though individually they are non stationary. Co-integration is based on the long run
relationship between variables. The idea arises from considering equilibrium relationships, where
equilibrium is a stationary point characterized by forces that tend to push the variables back
toward equilibrium.
In general, if Yt and Xt are both integrated of order I(d), then any linear combination or the two
series will also be I(d).. That is, the residuals obtained on regressing Yt on Xt are I(d).

If two or more series are co integrated then even though the series themselves may be non
stationary, they will move closely together over time and their difference will be stationary. Their
long run relationship is the equilibrium to which the system converges overtime and the
disturbance term Et can be construed as the disequilibrium error or the distance that the system is
away from equilibrium at time t
The Engle granger co integration test is a two step process:

1. First estimating an ordinary least square (OLS) regression on the data. A regression of one
integrated variable on the other integrated variables (x on y and y on x).
Yt = a + bx t + e t
X & Y will be co-integrated if and only if et is stationary.
2. Then testing these residuals from regression equation for stationarity using a unit root test of
ADF.
) JOHANSEN CO INTEGRATION TEST
Johansen’s methodology for investigating co integration in a multivariate system has been

preferred by many economists. it employs a better properties than the Engle granger’s method
and its less bias when there are more than two variables. This method is based on the Eigen
values and Likelihood ratio statistics. The Johansen tests seek the linear combination which is
most stationary where as the Engle – Granger tests being based on OLS seek the linear
combination having minimum variance. It identifies whether the series are co integrated or not
by examining the existence of no of co integrating equations in them. It checks the trace statistics
to the null hypothesis of no co integration equations and checks for the alternative hypothesis of
more than one co integrating equations.

) GRANGERS CAUSALITY TEST
Although regression analysis deals with the dependence of one variable on other variables, it
does not necessarily imply causation. In other words, the existence of a relationship between
variables does not prove causality or direction of influence. More generally, since the future
cannot predict the past, if variable X causes variable Y, then changes in X should precede
changes in Y.
Granger causality is a technique for determining whether one time series is useful in forecasting
another. Ordinarily, regressions reflect "mere" correlations, but Clive Granger causality test
shows about the causality between two series.
It measures the significance of past values of variable X in explaining variable Y, taking into
account the effect of past values of variable Y itself. Usually causal relations are tested both
ways, from X to Y and from Y to X.
A time series X is said to Granger-cause Y if it can be shown, usually through a series of F-tests
on lagged values of X (and with lagged values of Y also known), that those X values provide
statistically significant information on future values of Y.
The test works by first doing a regression of ΔY on lagged values of ΔY. Once the appropriate
lag interval for Y is proved significant (t-stat or p-value), subsequent regressions for lagged
levels of ΔX are performed and added to the regression provided that they 1) are significant in of
themselves and 2) add explanatory power to the model. This can be repeated for multiple ΔX's
(with each ΔX being tested independently of other ΔX's, but in conjunction with the proven lag
level of ΔY). More than 1 lag level of a variable can be included in the final regression model,
provided it is statistically significant and provides explanatory power.
If the computed f value exceeds the critical F values at the chosen level of significance, we reject
the null hypothesis, in which case the lagged y belongs in the regression. i.e. Y causes X.The
whole procedure should be repeated to test whether X causes Y.


EMPIRICAL RESULTS
GRAPH SHOWING DAILY PRICE MOVEMENTS
Movement of Daily Closing Prices Of NIFTY Spot

From 12 June 2000 to Mar 31 2006
4000
3500
3000
Spot closing Prices
2500
2000
1500
1000
500
0
No of Observations
Movement fo futures daily prices from June 12 2000 to

31 Mar 2006
3500
3000
Future closing prices
2500
2000
1500
1000
500
0
No of observations
INTERPRETATION
The above graphs show the daily price movements of Nifty index and Nifty Futures from 12th
Jun 2000 to 31st Mar 2006. These movements show that the series are non stationery since they
are showing a upward trend as the time changing. This has been further tested by following

Augmented dickey fuller Test.

) ADF UNIT ROOT TEST RESULTS FOR STATIONARITY OF THE
SERIES
AT LEVELS
H0 = Unit root : Non Stationary
H1 = No Unit root : Stationary
TABLE 01
Series Constraints Test Statistics at 1% at 5% at 10%
None 3.30207 ** -2.5671 -1.9396 -1.6157
Nifty spot prices Intercept 3.04568 ** -2.5671 -1.9396 -1.6157
(At lag 0) Trend and Intercept 0.09926 ** -2.5671 -1.9396 -1.6157
(** indicates acceptance of null hypothesis )
TABLE 02
Series Constraints Test Statistics at 1% at 5% at 10%
None 1.174202 ** -2.5671 -1.9396 -1.6157
Nifty future prices Intercept 0.293061 ** -2.5671 -1.9396 -1.6157
(At lag 0) Trend and Intercept 0.293061 ** -2.5671 -1.9396 -1.6157
(** indicates acceptance of null hypothesis )
INTERPRETATION
The ADF test has been conducted on both the nifty spot and nifty futures time series at their
levels. The test has been done at none, intercept, intercept and trend respectively. The results
show that the null hypothesis is accepted since ADF calculated values for nifty spot and nifty
futures are greater than the critical values at all the levels. (1%, 5%, 10%). There exists unit root
in the series. Therefore the both the series are Non Stationary. Since the results are showing that
the series are Nonstationary, then the series are transformed into first order difference to check

the Stationarity
** Reference Tables No 1, 2, 3, 4, 5, 6 ------- See Annexure
AT FIRST ORDER DIFFRENCE
H0 = Unit root : Non Stationary

H1 = No Unit root : Stationary
TABLE 03
Series Constraints Test Statistics Durbin at 1% at 5% at 10%

Watson Test
None -33.55160 * 1.965572 -2.5671 -1.9396 -1.6157
Nifty spot Intercept -33.65837 * 1.965593 -2.5671 -1.9396 -1.6157
prices
(At lag 0) Trend and Intercept -33.93419 * 1.965648 -2.5671 -1.9396 -1.6157
(* indicates rejection of null hypothesis )
TABLE 04
Series Constraints Test Statistics Durbin at 1% at 5% at 10%

Watson Test
None -53.82697 * 2.106065 -2.5671 -1.9396 -1.6157
Nifty spot Intercept -53.88135 * 2.107857 -2.5671 -1.9396 -1.6157

prices
(At lag 0) Trend and Intercept -54.04371 * 2.112291 -2.5671 -1.9396 -1.6157

** Reference Tables No 7, 8, 9, 10, 11, 12 ------- See Annexure
INTERPRETATION
The above Tables 3 and 4 show the results regarding the ADF test statistics after transforming the
series into first order difference .The ADF Test has been conducted to check the unit root in the
series. The ADF test statistics calculated for Nifty spot prices are 33.55160 and -53.82697 for
Nifty futures at none respectively which is not significantly different from the values at Intercept
and Trend & Intercept. These calculated values are less than the Mac Kinnon Critical values at
all the levels (1%, 5%, and 10%). This shows that the null hypotheses of Unit root is rejected at
all the levels. Therefore the both the series are Stationary.
Further, Durbin Watson test has been done to find out the auto correlation in the series. The
calculated values for spot prices and futures prices are 1.965572 and 2.106065 at none
respectively which is not significantly different from the values at Intercept and Trend &
Intercept. These values are close or greater than threshold value of 2. These show that the series
are Stationary at their first order difference.

) RESIDUAL BASED GARNGER’S CO INTEGRATION TEST
After obtaining the statinarity of the series at their first order difference, next residual based
granger’s co integration test has been conducted at their levels to know the long run relationship
between the Nifty spot prices and Nifty Futures prices. The residuals are obtained by following
the granger’s Ordinary Least Square method.
Residuals for Spot

e t = St -α - β F t ------------------------(1)
Residuals for futures

e t = Ft -α -βSt ----------------------(2)
TABLE 05
Regression coefficients Spot prices Future Prices

Α -11.657 16.309
β 1.012 0.985
In the above equations α and β are the regression coefficients which are obtained by regressing
the nifty index prices against the nifty futures prices. The regression coefficient β is positive for
both the series which gives a some idea that they are positively co integrated. After obtaining the
regression coefficients, the residuals are obtained form the equation (1) and (2). But this
relationship has been further studied by following ADF test.
** Reference Tables No 13, 14 ------- See Annexure

) AT LEVEL
TABLE 06
ADF TESTS TEST DURBIN AT 1% AT 5% AT 10%

STATISTICS WATSON
Spot prices -38.15346 * 1.9999 -2.5671 -1.9396 -1.6157
None Lag 0
Future Prices -38.15707 * 2.0000 -2.5671 -1.9396 -1.6157
The above Table 6 shows the results regarding the ADF test statistics obtained for residuals
obtained from the Granger’s Co integration Test .The ADF Test has been conducted to check the
unit root in the series. The ADF test statistics calculated for Nifty spot prices are -38.15346
-38.15707 for Nifty futures at none respectively. These calculated values are less than the Mac
Kinnon Critical values at all the levels (1%, 5%, and 10%). This shows that the null hypotheses
of Unit root is rejected at all the levels. Therefore the both the series are Stationary which shows
that the series are co integrated.
Further, Durbin Watson test has been done to find out the auto correlation in the series. The
calculated values for spot prices and futures prices are 1.965572 and 2.106065 at none
respectively which is not significantly different from the values at Intercept and Trend &
Intercept. These values are close or greater than threshold value of 2. These show that the series
are Stationary at their first order difference.
** Reference Tables No 15, 16 ------- See Annexure

) JOHANSEN COINTEGRATION TEST
Further Johansen Co integration test has been conducted on the price series which is preferred by
many economists. This test is very much suitable for the multivariate system and moreover this
overcomes the limitations of the Granger’s co integration test.
) FOR BOTH SPOT AND FUTURE PRICES

H0: r = 0 : No co integration
H1: r = 1 : co integration
TABLE 07
TESTS NULL EIGEN LIKELI HOOD AT 1% AT 5%

HYPOTHESIS VALUES RATIO
Lag 0 r=0 0.376356 699.6574* 12.53 16.31
Lag 1 r=0 0.390663 730.9832* 12.53 16.31
Lag 5 r=0 0.130991 211.4444* 12.53 16.31
r indicates no of co integration equations

INTERPRETATION
The above table shows the results of co integration between the Nifty spot prices and Nifty
futures prices. This test has been conducted at various lags to check the influence of past value of
one series against another series. The test results reveal that the calculated likelihood ratio is
greater than the critical values at all the lags compared to its critical values. The null hypothesis
is rejected at all the levels (1%, 5%, and 10%). That means three exists more than 1 co
integration equations. This shows that there is long run equilibrium relationship between Nifty
spot prices and Nifty future prices.
** Reference Tables No 17, 18, and 19 ------- See Annexure

) GRANGER’S CAUASLITY TEST

Since there exists long run relationship between Nifty spot prices and nifty futures prices, there
will be causal relationship between these series. That means there exists lead – lag relationship
between them. This should be examined to know which market lead and which market lag in
impounding the information in its prices. This relationship is examined by conducting Grangers
Causality test.
H0 = Futures does not cause Spot market

H1 = Futures causes Spot market
TABLE 08
TESTS F- STATISTICS P – VALUES AT 1% AT 5% AT 10%

(FUTERES)
Lag 2 439.112* 0.00000 1 1 1
Lag 5 162.731* 0.00000 1 1 1
Lag 12 67.8706* 0.00000 1 1 1
(* rejection of null hypothesis )

* Reference tables
INTERPRETATION
The above table shows the results that the calculated F values are significantly greater from the
critical values at all the lags (2, 5, 12). That means the null hypothesis is rejected and the
alternative hypothesis is accepted .That shows that there is causality from futures to spot market
in impounding the information in its prices. This tells that, any changes in futures prices causes
change in Spot prices. The prices changes in futures prices precede the changes in the Spot
prices. Moreover the probability values are close to 0 which tells that the probability of
occurrence of null hypothesis is 0.
** Reference Tables No 20------- See Annexure

TABLE 09
TESTS F- STATISTICS P - VALUES AT 1% AT 5% AT 10%

(SPOT)
Lag 2 2.21257** 0.10979 1 1 1
Lag 5 0.26713* 0.94586 1 1 1
Lag 12 1.23778* 0.99384 1 1 1
(** indicates acceptance of null hypothesis)
INTERPRETATION
The above table shows the results that the calculated F value is greater from the critical values at
lag 2but its p value is significantly different from zero. Moreover the calculated “F” values are
significantly lower at 5 and 12 lags which show that the null hypothesis is accepted at 5 and 12
lags. Moreover the probability values are close to 1 which tells that the probability of rejection of
null hypothesis is higher. That shows that there is no much causality from Spot market to Futures
market in impounding the information in its prices. This tells that, any changes in Spot prices do
not cause much change in Future prices.
Therefore the Grangers Causality Test results show that the Future markets are leading the spot
market in impounding future expectations about the future spot price. There is only
unidirectional causality from futures market to Spot market, which helps to conclude that the
Futures markets are more efficient in discovering the future Spot prices.
** Reference Tables No 20 ------- See Annexure


) ANALYSIS AND INFERENCES
The results of the present study are compared with the studies done by many other researchers.
Ash Narayan and Amit Kumar in their study found out that there exist long run relationship
between nifty spot and nifty futures prices. They found out that the two markets are co-
integrated. The investors can combine information of nifty spot and nifty futures prices to predict
future spot price.
Another study done by Dimitris F Keniurgois (2004) examined the relationship between price
moments of the FTSE/AE 20 futures market. The results showed that two markets are co
integrated. They also found out that there exists bi directional causality between stock index spot
and the futures market series as a focal point of information assimilation and fulfill their price
discovery.
Hector O Tapatra and T Ranball Forters Bery found out that futures market provide a price
discovery function. They also found that there is causal relationship between the two markets.
The present study done by me also shows the results which are similar to past studies. It shows
that there is long run equilibrium relationship between nifty spot index and the nifty index
futures. There exists causal relationship between both the markets. But the past studies have
shown that there in bidirectional causality between the markets, but the present study shown that
there is more of uni directional causality from future to market in feedback mechanism

) CONCLUSIONS
The empirical results of the study show that the there exists a long run equilibrium
relationship between Nifty Spot and Nifty futures. This long run relationship between these
two markets is evidenced by the Granger’s Co integration Test and Johansen co integration
Test. These tests show positive results towards co integration between Nifty Spot Prices
and Nifty Futures prices.
Further the results of Granger’s Causality test indicate that there is lead – lag relationship
between Futures market and Spot market. This shows that there is feedback mechanism
between Futures market and Spot markets. But the results significantly show that there is
more of unidirectional causal effect and feedback from Future market to Spot market in
impounding the information in its prices. The occurrence of changes in the futures prices
precede the changes in the Spot prices .This indicates that Futures market is leading the
spot market in discovering the prices for future’s Spot prices
So finally we can conclude that the Future market is efficient in discovering the Future
Spot price compared to Spot market


BIBLIOGRAPHY
REFERNCE BOOKS
¾ Basic Econometrics - Damodar N.Gujarati, (fourth edition)

¾ Options and Futures – H C Hull
¾ Market Models -- Indian Institute of Management, Bangalore
WEBSITES
¾ www.nseindia.com
¾ www.finance.yahoo.com
¾ www.google.com
¾ www.investorpedia.com
REFERNCE ARTICLES
¾ Efficient Price Discovery in Stock Index Cash and Futures market---By

PASCAL ALPHONSE----2000
¾ Price Discovery in cash and Futures Market---The case of S & P NIFTY and
NIFTY FUTUTRES----Ash Narayan Shah and Anil Kumar A(2006)
¾ Price discovery in the Athens Derivatives Exchange: Evidence for the FTSE/ASE
20 Futures Market---2004
¾ Stochastic interest rates and price discovery in selected commodity markets-----
By Hector. O. Zaptra and T . Randall Fortenbery---1995
¾ Study of common stochastic trend and co integration in the emerging markets –
A case study of India, Singapore and Taiwan ---- June 2003


TABLE 01
ADF RESULTS FOR NIFTY SPOT PRICES AT LEVEL, AT NONE, LAG 0
ADF Test Statistic 3.302079 1% Critical Value* -2.5671
5% Critical Value -1.9396

*MacKinnon critical values for rejection of hypothesis of a unit root.
Augmented Dickey-Fuller Test Equation

Dependent Variable: D(SPOT)
Method: Least Squares

Date: 06/12/06 Time: 10:46
Sample(adjusted): 1/05/2000 8/08/2005
Included observations: 1459 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
SPOT(-1) 0.001129 0.000342 3.302079 0.0010
R-squared 0.003508 Mean dependent var 1.344859

Adjusted R-squared 0.003508 S.D. dependent var 21.42071
S.E. of regression 21.38311 Akaike info criterion 8.963765
Sum squared resid 666652.2 Schwarz criterion 8.967388

Log likelihood -6538.067 Durbin-Watson stat 1.758413

TABLE 02
ADF RESULTS FOR NIFTY SPOT PRICES AT LEVEL, AT INTERCEPT,

LAG 0


Date: 06/12/06 Time: 10:56
Sample(adjusted): 1/05/2000 8/08/2005
SPOT(-1) 0.003025 0.000993 3.045687 0.0024
C -3.305759 1.626131 -2.032898 0.0422

Log likelihood -6536.000 F-statistic 9.276211
Durbin-Watson stat 1.766748 Prob(F-statistic) 0.002363

TABLE 03
ADF RESULTS FOR NIFTY SPOT PRICES AT LEVEL, AT TREND

ANDINTERCEPT, LAG 0


Date: 06/12/06 Time: 11:01
Sample(adjusted): 1/05/2000 8/08/2005
SPOT(-1) 0.000163 0.001639 0.099264 0.9209

C -2.419433 1.673461 -1.445766 0.1485
@TREND(1/03/2000) 0.004807 0.002190 2.194787 0.0283


TABLE 04
ADF RESULTS FOR NIFTY FUTURE PRICES AT LEVEL, AT NONE, LAG 0


Date: 06/12/06 Time: 10:20
Sample(adjusted): 1/05/2000 8/08/2005
SPOT(-1) 0.000813 0.000692 1.174202 0.2405

Sum squared resid 2703200. Schwarz criterion 10.36731
Log likelihood -7559.310 Durbin-Watson stat 2.666096

TABLE 05
ADF RESULTS FOR NIFTY FUTURE PRICES AT LEVEL, AT

INTERCEPT, LAG 0


Dependent Variable: D(FUTURES)
Date: 06/12/06 Time: 10:42
Sample(adjusted): 1/05/2000 8/08/2005
FUTURES(-1) 0.000594 0.002025 0.293061 0.7695

C 0.380141 3.297711 0.115274 0.9082

Adjusted R-squared -0.000627 S.D. dependent var 43.05971

TABLE 06
ADF RESULTS FOR NIFTY FUTURE PRICES, AT LEVEL, AT

TREND AND INTERCEPT, LAG 0


Dependent Variable: D(FUTURES)
Date: 06/12/06 Time: 10:42
Sample(adjusted): 1/05/2000 8/08/2005
FUTURES(-1) 0.000594 0.002025 0.293061 0.7695

C 0.380141 3.297711 0.115274 0.9082

Adjusted R-squared -0.000627 S.D. dependent var 43.05971

TABLE 07
ADF RESULTS FOR NIFTY SPOT PRICES AT FIRST DIFFRENCE AT

LEVEL, AT NONE, LAG 0
ADF Test Statistic -33.88683 1% Critical Value* -2.5671


Dependent Variable: D(SPOT1)
Date: 06/12/06 Time: 11:04
Sample(adjusted): 1/05/2000 8/08/2005
SPOT1(-1) -0.881882 0.026024 -33.88683 0.0000
R-squared 0.440589 Mean dependent var 1.77E-05

S.E. of regression 0.013836 Akaike info criterion -5.722349
Sum squared resid 0.279126 Schwarz criterion -5.718726
Log likelihood 4175.454 Durbin-Watson stat 1.971032

TABLE 08
SHOWING ADF RESULTS FOR NIFTY SPOT PRICES, AT FIRST

DIFFRENCE AT LEVEL, AT INTERCEPT, LAG 0


Date: 06/12/06 Time: 11:05
Sample(adjusted): 1/05/2000 8/08/2005
SPOT1(-1) -0.883516 0.026037 -33.93323 0.0000

C 0.000538 0.000362 1.483946 0.1380

Log likelihood 4176.555 F-statistic 1151.464

TABLE 09
ADF RESULTS FOR NIFTY SPOT PRICES, AT FIRST DIFFRENCE AT

LEVEL, AT TERND AND INTERCEPT, LAG 0


Date: 06/12/06 Time: 11:06
Sample(adjusted): 1/05/2000 8/08/2005

SPOT1(-1) -0.888254 0.026058 -34.08777 0.0000

C -0.001040 0.000725 -1.435114 0.1515
@TREND(1/03/2000) 2.16E-06 8.60E-07 2.512881 0.0121



TABLE 10
ADF RESULTS FOR NIFTY FUTURES PRICES, AT FIRST DIFFRENCE
AT LEVEL, AT NONE, LAG 0
Dependent Variable: D(FUTURE1)
Date: 06/12/06 Time: 11:07
Sample(adjusted): 1/05/2000 8/08/2005
FUTURE1(-1) -1.491268 0.022812 -65.37246 0.0000
Log likelihood 1047.590 Durbin-Watson stat 2.319526

TABLE 11
AT LEVEL, AT INTERCEPT, LAG 0


Date: 06/12/06 Time: 11:11
Sample(adjusted): 1/05/2000 8/08/2005
FUTURE1(-1) -1.491296 0.022819 -65.35250 0.0000

C 0.000885 0.003092 0.286275 0.7747


TABLE 12

AT LEVEL, AT TREND AND INTERCEPT, LAG 0


Date: 06/12/06 Time: 11:12
Sample(adjusted): 1/05/2000 8/08/2005
FUTURE1(-1) -1.491378 0.022826 -65.33734 0.0000
C -0.001752 0.006194 -0.282906 0.7773
@TREND(1/03/2000) 3.61E-06 7.34E-06 0.491403 0.6232


TABLE 13
REGERSSION COEFFICIENTS FOR SPOT RESIDUALS
Unstandardized Standardize t Sig.

Coefficients d
Coefficients
Model B Std. Error Beta

1 (Constant) -11.657 2.430 -4.797 .000
FUTURE 1.012 .001 .998 679.064 .000
Dependent Variable: SPOT
TABLE 14
REGERSSION COEFFICINETS FOR FUTURE RESIDUALS
Unstandardized Standardize t Sig.

Coefficients d
Coefficients
Model B Std. Error Beta
1 (Constant) 16.309 2.378 6.858 .000
SPOT .985 .001 .998 679.064 .000
Dependent Variable: FUTURE

TABLE 15
JOHANSEN COINTEGARTION RESULTS AT LAG 0
Sample: 1/03/2000 12/29/2006
Included observations: 1459
Test assumption: No deterministic trend in the data
Series: SER01 SER02
Lags interval: No lags
Likelihood 5 Percent 1 Percent Hypothesized

Eigenvalue Ratio Critical Value Critical Value No. of CE(s)
0.376356 699.6574 12.53 16.31 None **
0.007344 10.75380 3.84 6.51 At most 1 **
*(**) denotes rejection of the hypothesis at 5%(1%) significance level
L.R. test indicates 2 cointegrating equation(s) at 5% significance level
Unnormalized Cointegrating Coefficients:
SER01 SER02
-0.000650 0.000647
4.00E-05 -2.38E-05
Normalized Cointegrating Coefficients: 1 Cointegrating Equation(s)
SER01 SER02
1.000000 -0.995709
(0.00083)
Log likelihood -13749.63

TABLE 16
JOHANSEN COINTEGARTION RESULTS AT LAG 1 TO 1
Sample: 1/03/2000 12/29/2006
Series: SER01 SER02
Lags interval: 1 to 1
0.390663 730.9832 12.53 16.31 None **
0.005959 8.713743 3.84 6.51 At most 1 **
SER01 SER02
-0.000823 0.000820
6.17E-05 -4.53E-05
SER01 SER02
1.000000 -0.996281
(0.00064)

TABLE 17
JOHANSEN COINTEGARTION RESULTS AT LAG 1 TO 5
Sample: 1/03/2000 12/29/2006
Series: SER01 SER02
Lags interval: 1 to 5
0.130991 211.4444 12.53 16.31 None **
0.005008 7.300619 3.84 6.51 At most 1 **

SER01 SER02
-0.001521 0.001515
1.52E-05 1.23E-06
SER01 SER02
1.000000 -0.996090
(0.00073)

TABLE 18
GRANGER’S CAUSALITY TEST RESULTS

AT LAG 2, LAG5, and LAG 12
Pairwise Granger Causality Tests
Sample: 1/03/2000 12/29/2006
Lags: 2
Null Hypothesis: Obs F-Statistic Probability
SER02 does not Granger Cause SER01 1458 439.112 0.00000
SER01 does not Granger Cause SER02 2.21257 0.10979
Sample: 1/03/2000 12/29/2006
Lags: 5
Sample: 1/03/2000 12/29/2006
Lags: 12



Lakshmi-0483-Price Discovery in Cash&amp; Futures Market

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Price discovery in Cash and Futures Market

“Price Discovery in Cash and Future markets”

M.P.Birla Institute of Management

M P Birla Institute Of Management 1

markets ” is prepared under the guidance of Dr.N.S. Mallavalli in partial

fulfillment of MBA degree of Bangalore University, and is my original work.

under Bangalore University or any other university.

M P Birla Institute Of Management 2

This is to certify that Ms. Lakshmi S N, bearing Registration No: 04XQCM6046

under the guidance of Dr. N.S.Mallavalli, M P Birla Institute of Management,

any other university.

Place: Bangalore Dr.N.S.MALLAVALLI

Date: MPBIM, Bangalore

M P Birla Institute Of Management 3

completed by Miss. Lakshmi .S. N under my guidance and supervision.

Place: Bangalore Dr. N S MALLVALLI

M P Birla Institute Of Management 4

Date: MPBIM, Bangalore

I am thankful to Dr.N.S.Malavalli, Principal, M.P.Birla institute of management,

I am extremely thankful to Prof. Dr.N.S.Malavalli , M.P.Birla institute of

M P Birla Institute Of Management 5

CHAPTERS PARTICULARS PAGE NO.

1.1 Introduction and Background of the study 1-7

Theoretical Framework 8 -15

3.1 Hypothesis Statements 21

3.2 Data sampling details 22 - 23

3.2 Statistical Models 24 - 29

4. DATA ANALYSIS AND INTERPRETATION

5. INFERENCES AND CONCLUSIONS 39 - 40

M P Birla Institute Of Management 6

M P Birla Institute Of Management 7

M P Birla Institute Of Management 8

M P Birla Institute Of Management 9

M P Birla Institute Of Management 10

M P Birla Institute Of Management 11

) BACKGROUND OF THE STUDY

• CURENT CASH PRICE

M P Birla Institute Of Management 12

• EXPECTED CASH PRICE

M P Birla Institute Of Management 13

) OBJECTIVES OF THE STUDY

M P Birla Institute Of Management 14

) SCOPE OF THE STUDY

) LIMITATIONS OF THE STUDY

M P Birla Institute Of Management 15

M P Birla Institute Of Management 16

A futures contract is a standardized, transferable, exchange-traded contract that requires delivery

M P Birla Institute Of Management 17

) ADVANTAGES OF FUTURES TRADING

M P Birla Institute Of Management 18

2. PROFIT IN BOTH BULL & BEAR MARKETS

3. LOWER TRANSACTION COST

) S & P CNX NIFTY

M P Birla Institute Of Management 19

) S&P CNX NIFTY FUTURES

A futures contract is a forward contract, which is traded on an Exchange. NSE commenced

Instrument type represents the instrument i.e. Futures on Index.

M P Birla Institute Of Management 20

Expiry date identifies the date of expiry of the contract

) FUTURES PRICE FORMATION

M P Birla Institute Of Management 21

FtT – St = Et (p(t,T)+ Et (ST – St)

M P Birla Institute Of Management 22

Lakshmi-0483-Price Discovery in Cash& Futures Market

Lakshmi-0483-Price Discovery in Cash& Futures Market