| Price discovery, the process by which the diverse information of the participants of financial markets comes to be reflected in the actual prices at which trades take place, is an important function of financial markets because asset prices represent a consensus opinion of what market participants think about the future value of the asset. The price discovery function is particularly important to the foreign exchange markets because exchange rates are heavily influenced by information concerning economic, political and social factors that is widely dispersed among a large number of traders. The foreign exchange markets present a unique opportunity to study price discovery, since the markets differ in two important ways which various models predict are important to the price discovery process. The interbank market where spot foreign exchange is traded has a much larger volume of noise, or liquidity trading, and rational expectations models predict that prices are more informative in a market with more noise trading. However, the market microstructure of the futures exchange is designed to facilitate the price discovery process, and price discovery is an explicit goal.; This study attempts to determine in which market price discovery occurs by investigating the intertemporal relationship between returns in the two markets using a unique data set which consists of five-minute returns in the U.S. dollar/Japanese Yen spot exchange contract traded on the interbank market and the {dollar}/Y futures contract traded on the International Monetary Market of the Chicago Mercantile Exchange (CME). Lead and lag relationships between the two markets during this time period were analyzed by running a Generalized Least Squares time series regression of leading and lagged spot returns on current futures returns that takes into account observed autocorrelation in the regression residuals.; The futures and spot markets were very closely linked over this period, since prices in the two markets reacted within five minutes of each other to new information most of the time, even during periods in which price discovery was most likely to occur. Therefore, neither market was exclusively the place for price discovery. |
