Price discovery and hedging effectiveness in emerging markets across Asia Pacific

Futures markets play a significant role in stock markets in terms of price discovery and in hedging the price risk. While there have been an extensive number of theoretical and empirical studies conducted about the two main functions of futures markets in the developed markets, few studies exist that examine the case of the developing markets. The accuracy of price discovery and hedging is particularly important in the Asia Pacific emerging markets, considering the recent Asian and global financial crises and the substantial increases in the sizes of these markets. Additionally, it is theoretically established that when accurate price discovery is attained through a greater contribution of futures markets the hedge is more effective. The critical lack of research about this interrelationship is rather obvious. This dissertation describes the existing methods to investigate the relationship between spot and futures prices, identify the optimal hedge ratio, and motivate, propose and implement a new method to evaluate the interrelationship between accurate price discovery and hedging effectiveness. Malaysia’s FBM KLCI, Singapore’s STI, Japan’s NIKKEI 225, traded in the Singapore exchange, and South Korea’s KOSPI 200 are examined using data from the inception of the associated futures markets to March 2013. The empirical evidence indicates that futures markets generally contribute more to the price discovery process than spot markets. When comparing the indexes, it was determined that the spot and futures NIKKEI 225 impounds new information faster than the other indexes, while the FBM KLCI attains the highest contribution of futures markets in the process of price discovery. Moreover, the futures contracts with a moderate time to maturity play the dominant role. Furthermore, examining the various hedging methods illustrated that the cointegration approach, with structural breaks, provides the most effective hedge ratio in which the constructed portfolio retains the lowest price risk. This is a noble finding, as it signifies that investors using this method would relish the advantages of a dynamic hedge ratio with minimal transaction costs. The greatest hedging effectiveness was found to be achieved in the NIKKEI 225 next month contract. Ultimately, the proposed method upholds the theory, suggesting that a greater contribution of futures markets is essential in obtaining higher hedging effectiveness for longer time horizons. The result also verifies the well-recognised bi-directional causality between the aforementioned concepts. Further studies may apply alternative measures and methods to test the robustness of the findings.

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