Examining the lead lag relationship between cash markets and the derivatives based on them

Abstract

Inefficient capital markets, it is generally believed that the underlying stock prices have an impact on the price of the derivatives as governed by the Black schools model. For example, if the underlying stock appreciates in value, the price of the call option on that underlying will tend to increase in value, while the price of a similar put option decreases in value. There are players that operate only in derivative markets because they are incapable of operating in stock markets due to high investment requirements. These players are generally at the mercy of stock price movements affecting their positions in the derivative market –either due to fundamental changes in stock value or pure speculation. Either way, they are essentially reactive participants who, According to traditional financial theory, cannot influence the behavior of the underlying. However, a reverse phenomenon has recently been observed in the more developed capital markets. According to Frino, Walter, and West (2004), the derivative price movements have a reverse impact on the prices of the underlying stocks. This is highly advantageous for people dealing actively in the derivative market when there are macroeconomic releases. Investors with better market-wide information, therefore, prefer to deal in the derivatives market rather than the cash market. This phenomenon provides an opportunity to traders who do not hold the asset actually to influence its price. It can be a hugely advantageous trading strategy to pursue traders who have simultaneous positions in both the cash and the derivative market.