CSNZ
Understanding lead/lag and price discovery in the Australian Equity Index and Options Market
By Klaus Buhr, PhD, MBA, guest contributor, Chartered Secretaries New Zealand Inc

Financial markets are defined by the trading and settlement technologies they employ, regulations, market participants, traded instruments information mechanisms, and the information trading protocols which surround these technologies and mechanisms. These institutional details are important, as the trading systems and regulations affect the liquidity, transaction costs, and efficiency of the market. In perfectly frictionless and rational markets, the prices of securities and security derivatives must simultaneously reflect the incorporation of information into prices, otherwise costless arbitrage profits would be possible. Recent developments in trading and telecommunication technologies have increased the information efficiency of financial markets. As a result, market participants can access and assimilate information at low cost, and asset prices can rapidly reflect the information. Under an efficient market, information processing should be expeditious and the most information-efficient market should lead the others. Hence, information transmission or price discovery is an indication of the relative market efficiencies of related assets.

Australia has two exchanges, namely the Australian Stock Exchange (ASX) and the Sydney Futures Exchange (SFE). Apart from individual stocks, the ASX is also an exchange for trading index options. The All Ordinaries Index was the main stock market index from 1980 to 2000. As the Australian investment community became more sophisticated, the role of the All Ordinaries changed as investors began using the index to closely track or benchmark the performance of their investments. It was based on the top 300 shares listed on the ASX. In 2000, the ASX introduced new indices, the most important of which were the ASX 100, ASX 200, and ASX 300. These indices were based on the largest companies, measured by market capitalisation and the most actively traded shares listed on the ASX. The ASX sold its index business to Standard & Poor’s, and the indices are now known as the S&P/ASX 100, S&P/ASX 200, and S&P/ASX 300. With extensive use by institutional investment managers, mutual fund managers, and professional advisers, an estimated A$200 billion in funds under management is benchmarked to the S&P/ASX 200.

The returns on derivative securities, such as stock index options and futures contracts with pay-off structures, can be replicated by a portfolio of stocks, and bonds should not lead or lag returns on the spot index. Option markets provide a means of hedging positions held in underlying markets. Informed traders utilise option markets, given the higher leverage they offer compared to the underlying market. Evidence that the options market leads the stock market provides some support for the notion that option markets are used by informed traders to make speculative profits. Conversely, evidence that the stock market leads the options market supports the notion that options are used primarily to hedge positions held in the underlying stocks. One aspect of the price-discovery function of the share market is establishing the value of companies and their shares, and any share market will have a number of indices designed to reflect changes in the value of listed securities. Share index options enable investors to trade on general share market movements. Investors expecting a market rise buy call options and investors expecting a market decline buy put options. The possible losses (premium) are known at the outset of the transaction, but potential gains can be large. A change in the underlying index of less than one per cent can result in a change in the value of the contract of 15 per cent or more.

I investigated the lead/lag relationship and price discovery between the S&P/ASX 200 Share Price Index and the S&P/ASX 200 Index Options traded on the ASX. Share index options enable investors to trade on general share market movements. Empirical research into lead/lag relations between stock indices and index derivatives has been inconclusive. Most of the research on stock and option markets has been focused on US markets (NYSE, AMEX, OTC, and CBOT), but these are dealer markets with less than full automation. Researchers conclude that causality runs from the options market to the cash market. The ASX is a competitive order-matching market with full automation, suggesting that different market structures may give rise to different spreads.

An assessment is made of the nature of the short-run and long-run equilibrium relationships between the stock prices implied by the S&P/ASX 200 Index Options prices and the S&P/ASX 200 Share Price Index, with a co-integration approach and an error-correction model to test the causal relationships. The direction of this association is also determined (ie whether the S&P/ASX 200 Share Price Index tends to lead changes in the S&P/ASX 200 Index Options, or vice versa). Co-integration between these markets means they share a common stochastic trend. This implies one market will be useful in predicting the other market’s returns and a valid error-correcting presentation will exist. The series tend to drift together and are not far apart over time. Price discovery is the process by which new information is revealed by markets participants and incorporated into observable asset prices. Arbitrage activities should keep prices in the index and option markets from diverging. The prices of the two markets should be co-integrated and be driven by one common factor, which is also known as the “implicit efficient price”. We investigate the common driving force mechanics in price discovery for the index and option market and adapt two approaches to investigate the mechanics of price discovery. Both are based on a decomposition of transaction prices into a permanent component associated with the efficient price of the asset and a transitory component, which reflects noise. The efficient price should be identical in both the index and option markets, while the transitory component may differ. We want to establish which market information is first incorporated into the efficient price.

I also apply impulse-response analysis, which outlines the dynamic response of each variable to innovations from other individual variables in the system. The impulse-response function traces the impact of a one-time, unit standard deviation, positive shock to one variable on the current and future values of the endogenous variables.

The long-run equilibrium relationship between the share price index and the implied price of the share-price-index option was investigated. Causality was determined to show which market leads the other. Information-share measures were used to gauge the contribution of the share price index and index option markets to the price-discovery process. A shock to the option market indicates the index market does not respond strongly and only has a weak response. A shock to the index markets triggers a strong response from the option market. The impulse-response paths indicate the options market contributes less to discovering information about the underlying asset, but investors overreact to its innovations while discounting the more informative index market events.

Unambiguous evidence showed the index market leads the options market and the former contributes more to price discovery than the latter. Little evidence is available concerning the lead/lag and price-discovery relationships on the index and option markets in Australia. The results, contrary to other literature, indicate the index market plays the primary role in the price discovery in Australian markets. Traders need to know what affects prices of share price indices or index options when investigating possible investments. Unambiguous evidence indicates the index market leads the option market, so the former contributes more to determine accurate prices than the latter, allowing investors to make better sell or buy decisions. The results are of interest to individuals and institutional traders when they make buy and sell decisions. Ultimately, dependable prices allow markets to operate effectively, giving policymakers and small investor’s confidence that market prices are fair.

The contributions from CSNZ members and guests are the opinions of the authors and content is not necessarily a statement of CSNZ policy.

NZLawyer \\ issue 181 \\ 5 April 2012