Last Updated on 22 April, 2023 by Samuelsson
In financial markets, it is widely believed that the futures market leads the spot market due to the early incorporation of new information. This hypothesis has been confirmed in a study by Brooks, Rew, and Ritson, who investigated the lead-lag relationship between the FTSE 100 index and futures prices. In this article, we will summarize their findings and explore how traders can utilize this relationship to develop profitable trading strategies.
The Lead-Lag Relationship between FTSE 100 Index and Futures Prices
Using ten-minute observations, Brooks et al. found that lagged changes in futures prices can help predict changes in spot prices. This supports the hypothesis that the futures market leads the spot market in disseminating new market-wide information. This makes sense since trading in futures markets is generally more cost-effective than spot markets, enabling arbitrageurs to maintain the cost of carry relationship across both markets.
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The Best Forecasting Model: ECM-COC
The best forecasting model identified by Brooks et al. is the cost of carry error correction model (ECM-COC). This model predicts the correct direction of spot returns 68.75% of the time. The ECM-COC model allows for the theoretical difference between spot and futures prices based on the cost of carry relationship. This means that traders can take advantage of any divergence from this theoretical relationship to make trading decisions.
Trading Strategy Based on ECM-COC Model
Brooks et al. developed a trading strategy based on the ECM-COC model, which is tested under real-world conditions to identify systematic profitable trading opportunities. The results show that the model forecasts produce significantly higher returns than a passive benchmark. In the absence of transaction costs, a monthly return of 15.62% is obtained, compared to 4.09% for the passive benchmark.
However, when transaction costs are taken into account, the model is unable to outperform the benchmark. This is because transaction costs and slippage times can prevent a viable trading rule based on the model. Nonetheless, traders can use the model to identify optimum timing for trades or develop alternative strategies with lower transaction costs, such as a market maker.
In conclusion, the lead-lag relationship between spot index and futures contract provides a useful tool for traders to develop profitable trading strategies. The ECM-COC model is the best forecasting model, allowing traders to predict the direction of spot returns. Although the model is unable to outperform the benchmark after allowing for transaction costs, there are potential circumstances for utilizing the results, such as optimum timing for trades or by a trader with significantly lower transaction costs.