RDP 8804: Pricing Behaviour in Australian Financial Futures Markets 1. Introduction

The rapid growth of trading in financial futures markets has raised important questions about the effect of futures trading on prices in the associated spot markets. One view is that futures markets tend to improve efficiency and price stability in the spot markets by making those markets more liquid. This occurs because the distinctive features of futures markets, namely their highly standardised contracts and the fact that they are relatively unregulated, generally enable them to operate with very low transactions costs. On the other hand, it has been suggested that these very features of low cost and lack of regulation may actually exacerbate spot price volatility by encouraging excessive speculative activity. Concerns of this kind have recently been highlighted by the October sharemarket crash, when it was noted that sharp falls in the price of share index futures preceded major price movements on the New York Stock Exchange. This paper aims to review the theory and evidence on the role and performance of financial futures markets, and to present comparable evidence on recent performance of the Australian markets. Three futures contracts are specifically studied: these are the share price index contract and the 90-day and 10-year interest rate contracts, which together have accounted for the bulk of trading on the Sydney Futures Exchange during the last four years.

To provide a broad perspective on the issues, section 2 of the paper begins by briefly reviewing theories on the economic role of futures markets and the possible consequences of futures trading. This is followed in Sections 3 and 4 by a preliminary discussion of data on the recent behaviour of futures markets in Australia, and a review of relevant empirical work, undertaken mainly in the U.S. The remainder of the paper, in sections 5 and 6, sets out a framework for empirical testing with the Australian data, and presents the results.