One of the important functions of the futures market is price discovery. Futures market provides a mechanism through which information about current and future spot prices can be assimilated and disseminated to all participants in the economy. The futures trading in India started with the introduction of index futures on NSE and BSE in June 2000. This paper examines whether or not the futures trading in India is performing its primary role of price discovery. It employs co-integration and error correction method using data from June 12, 2000 through March 31, 2005. The results establish that there exists a long run relationship between Nifty spot and Nifty futures prices. Further, the error correction model leads to the conclusion that there exists a feedback mechanism between Nifty spot and Nifty futures.

Futures markets have two important functions in the economy—providing hedge facilities and price discovery. The ability of futures markets to provide information about prices is a central theme for the existence of these markets. In order to obtain an optimum allocation of resources in an economy, prices must accurately reflect relative production costs and relative consumption utilities. Futures markets, by providing a mechanism through which information about current and future spot prices can be assimilated and disseminated to all participants in the economy, help to achieve this goal.

All these prices are the result of open and competitive trading and reflect the underlying supply and demand for a financial asset or a good, both in the present and at various times in the futures. More specifically, in the case of future delivery, future prices reflect current expectations about what the supply and demand for a commodity or a financial asset are likely to be at different times in future. As such futures prices discover ‘expected’ spot prices: The equilibrium spot prices that are expected to prevail at various times in the future. In India, derivatives were introduced as a part of financial market reforms to hedge price risk which started in 1990s. These reforms were aimed at enhancing competition, transparency, and efficiency in the Indian financial market. This was initiated by the Government of India through L C Gupta Committee Report. The L C Gupta Committee on Derivatives had recommended in 1997 its introduction in a phased manner. Accordingly, stock index futures were introduced on Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) in the first.

Applied Finance Journal, Futures Market, Indian Financial Market, National Stock Exchange, NSE, Research Methodology, Error Correction Model, ECM, Engle-Granger methodology, Ordinary Least Square method, OLS, Stock Index Futures, Options Market, Augmented Dickey-Fuller Tests, ADF.