Price Discovery in the Foreign Currency Futures and Spot Market

Abstract

One of the perennial questions in derivatives research is how the derivatives market interacts with the market for its underlying instrument. Is the underlying dominant and its associated futures market just a satellite that follows along behind? Or does trading in the futures market push prices in the underlying around, maybe even driving both markets away from equilibrium at times? In this article, the authors examine the question of cash-futures interaction in foreign currency futures. Currency futures traded at the International Monetary Market division of the Chicago Mercantile Exchange have long been quite active, although still much smaller than the cash market. The relationship between intraday exchange rate movements in cash and futures is examined during 1996 and 2006. Interestingly, in 1996, futures price changes mostly led those in the cash market; while in 2006, the direction of influence was largely reversed. The authors believe this change primarily reflects increased transparency of the cash FX market.