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

This article 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.