ECONOMETRIC ANALYSIS OF LEAD-LAG RELATIONSHIP IN FINANCIAL DERIVATIVES MARKET IN INDIA

The issue of price discovery on futures and spot markets and the lead-lag relationship are topics of interest to traders, financial economists and analysts. Although futures and spot markets react to the same information, the major question is which market reacts first. This paper examines the lead/lag relationships between the NSE Nifty stock market index (in India) and its related futures and options contracts, and also the interrelation between the derivatives markets. The sample period covered is from July 2001 to March 2007. We examine returns at hourly intervals across the trading day taking five hourly sub-periods. The relative rates of price discovery across the cash and derivative markets are assessed with multiple regression models. The study finds that both the index futures and index options contracts lead the cash index. The call options market tends to lead the cash market by up to one hour. A feedback relationship is found between the cash market and the put option market with a lead and lag of up to an hour. A similar but stronger relationship is reported for the linkage between options and futures markets, with call options leading futures but futures leading puts. We hypothesize that informed traders with bullish expectations wishing to gain leverage from the options market will buy calls or, with greater risk, sell puts. As market sentiment was bullish for most of the sample period examined, this could explain the call market leads reported.