The paper explores the lead-lag relationship between the variables of order imbalance and return in futures and spot markets. Order imbalance is defined as the difference between buyer and seller initiated trades. Using tick test, the trades have been classified as buyer and seller initiated. The paper finds positive correlation between the variables of order imbalance in the futures market and the returns in the spot market. This relationship is further explored using a VAR framework for daily as well as a shorter interval of 120 min. The results reveal that even after controlling for lagged futures and spot returns, the futures market imbalance has a significant effect on spot market returns.

The variables of order imbalance and returns would show a relationship because information will first get reflected in the orders (thereby affecting order imbalance) which would in turn affect the prices and hence returns. However, with the introduction of derivatives market, the information is more likely to flow first to the futures market rather than to the spot market. This is so due to high leverage, low transaction costs and provision of short selling in the futures market in comparison to the spot market. The information would finally reflect in spot prices as well to bring them in line with the futures prices (otherwise there would be arbitrage opportunities between the two markets). The above process would result in some lead-lag relationships between the variables of futures market (futures market order imbalance and futures market returns) with the spot market variables (spot market order imbalance and spot market returns).

Theoretically, the value of futures contract should be equal to its spot value and the interest cost involved in holding the contract till maturity. So if the interest is constant, then futures and spot markets should exhibit a high degree of contemporaneous correlation. However, this fails to happen in real market conditions due to the differences in trading mechanism in both the markets. The main differences between the derivative and spot markets are on account of different transaction costs, absence of short selling in spot market and use of leverage in transactions in the futures market. Transaction cost for a similar trade value is higher in spot market than in futures market, thus making it more costly to trade in spot market. Short selling, which is a mechanism to sell securities without possessing them, is banned in the spot market. However, the investor can sell a derivative on a stock or index in the futures market. This enables an insider to trade on negative information in the futures market thus reflecting the information in prices in the futures market. The facility of leverage allows an investor to buy/sell a contract of value which is 8 to 10 times that of his investment. This feature is again absent in the spot market. Put together, these three factors allow the prices in futures market to reflect the information faster as compared to the spot market.

Financial Risk Management Journal, NYSE, AMEX and NASDAQ, Order Imbalance, Returns, Evidence, ICICI Bank, ONGC, Ranbaxy, Reliance, SBI, Lead-Lag Relationship.