The Role of Futures in Financial Markets
November 26th, 2010
Without financial futures, investors would have only one trading location to alter portfolio positions when they get new information that is expected to influence the value of assets—the cash market. If economic news that is expected to impact the value of an asset adversely is received, investors can reduce their price risk exposure to that asset. The opposite is true if the new information is expected to impact the value of that asset favorably: an investor would increase price-risk exposure to that asset. There are, of course, transaction costs associated with altering exposure to an asset—explicit costs (commissions), and hidden or execution costs (bid-ask spreads and market impact costs).
Futures provide another market that investors can use to alter their risk exposure to an asset when new information is acquired. An investor will transact in the market that is the more efficient to use in order to achieve the objective. The factors to consider are liquidity, transaction costs, taxes, and leverage advantages of the futures contract. The market that investors feel is the one that is more efficient to use to achieve their investment objective should be the one where prices will be established that reflect the new economic information. That is, this will be the market where price discovery takes place. Price information is then transmitted to the other market. It is in the futures market that it is easier and less costly to alter a portfolio position. Therefore, it is the futures market that will be the market of choice and will serve as the price discovery market. It is in the futures market that investors send a collective message about how any new information is expected to impact the cash market.
How is this message sent to the cash market? We know that the futures price and the cash market price are tied together by the cost of carry. If the futures price deviates from the cash market price by more than the cost of carry, arbitrageurs (in attempting to obtain arbitrage profits) would pursue a strategy to bring them back into line. Arbitrage brings the cash market price into line with the futures price. It is this mechanism that assures that the cash market price will reflect the information that has been collected in the futures market.
Filed under: Financial Markets