This paper investigates the hypothesis that the recently established Nifty Index Futures Market effectively serves the price discovery function in the underlying spot market. Johansen's Cointegration, Vector Error Correction Model and Generalized Impulse Response Analysis are applied to test the hypothesis on daily data from NSE. Bilateral causality is observed between Nifty Index and Nifty Index Futures. The evidence supports the hypothesis suggesting that the futures market in India is a useful price discovery vehicle.

Futures is the biparty contract on the current underlying asset (may be commodity or a financial instrument) to be settled on a prespecified future date at a predetermined price. The underlying is traded in the cash or spot market at the market price (Po). The futures price (Pt) represents the price of the underlying at some future point of time. The difference between the futures price and the spot price is known as the basis. Thus, Basis = Pt - Po If the asset to be hedged and the asset underlying the futures contract is the same, the basis should be zero at the expiration of the futures contract. Prior to expiration, the basis may be positive or negative. The uncertainty regarding the time to buy or sell the asset and to close the futures contract is termed as basis risk.

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