Introduction and summary

What is the effect of the introduction of a futures contract on the spot price of the underlying asset? Empirical research has attempted to measure the effects of futures transactions on the volatility of spot prices. However, we believe that there are situations, related to some kind of market imperfections and investors' risk aversion and heterogeneity, where one should also be able to detect an effect on the price, i.e. on the required return of the underlying asset.

In Section 2 of the chapter we motivate our theoretical a priori. We show that, with risk averse investors in the spot market, and if opportunities to hedge interest rate risk were not easily available before the introduction of the futures contract, then in some instances the introduction of such a contract will reduce the required excess return on the underlying asset.

In Section 3 of the chapter we develop an appropriate methodology for testing our conjecture. The excess return on a risky asset may be modelled in terms of premia attached to some specific risk factors, in the tradition of the APT model (Ross, 1976, 1977). Following the introduction of a futures contract, and if it can be argued that this provides new opportunities to hedge interest rate risk, then the premium related to this specific risk factor should decrease significantly.