The basis under negative shock and the price discovery in futures market

Abstract

This article examines the informational content of the basis under positive and negative prior shocks, and its linkage to the relationship between the Indian stock index spots and futures contracts. The leading role of the futures market in the spot markets is confirmed. Furthermore, the strengthening positive or negative basis under negative prior shocks has different levels of leading relationship in futures and spot returns. Adopting the different subdivided scenarios and employing different interactions in terms of dummy variables which describe the absolute value of a positive or negative basis under negative prior shock, this article finds that the positive relationship between the futures return and spot return is relatively weaker in terms of the strengthening positive basis, but is relatively stronger under negative prior shocks. In contrast, the leading role of the futures markets is relatively stronger in terms of the strengthening negative basis, but is weaker under negative prior shocks. This result reflects the fact that investors’ perceived uncertainty of ‘negative prior shocks’ will change the original connection of futures and spot returns, considering the strengthening basis. Coincidentally, this article fails to find that the spot returns lead the futures prices.