"The right policy for the development of Hong Kong's cash and futures markets is to enhance efficiency within both markets and the link between the two," states Professor KC Chan, Associate Dean and Head of Finance, School of Business and Management, Hong Kong University of Science and Technology. Professor Chan is also a Board Member of the Hong Kong Futures Exchange.

Professor Chan makes the above remark in the second of a planned series of educational articles published today by the Economic Research Department of the Hong Kong Futures Exchange.

"The cash market and the futures market have different roles to play in the process of price discovery," says Professor Chan. "Contrary to common belief, prices in the futures market are actually just as real as prices in the cash market."

"It is only fair to say that the futures market specialises in trading on macro-level information and the stock market on firm-level information," he adds.

"It does not, however, imply that the futures market can set prices without help from the stock market. Stock market prices and trading volume reveal important information about demands and risk appetites of investors in the market. The futures market aggregates this information together with that revealed in the futures trades to set new prices," Professor Chan continues.

"Although the cash market can do similar information aggregation, one would expect that the futures market can get this done faster than the cash market. The bottom line is that prices in the futures market generally lead prices in the cash market, but this does not imply at all that the cash market is passive," he explains.

Professor Chan goes on to say, " This only means that the futures market can aggregate information slightly quicker. Statistically speaking, a lead and lag pattern is observed in many markets, including those in Hong Kong."

"Unfortunately, the public often mistakes this statistical correlation to mean that the futures market actually usurps the role of the 'real' stock market," he laments.

He adds that increasing the cost of trading in the futures market will reduce the liquidity and market depth, which will in turn increase volatility.

"Measures that try to limit the size of the futures market or increase the costs of trading there, including raising margins and imposing position limits beyond what are required for clearing house risk management purposes, do not stabilise the financial market," he asserts.

"Consider the investor who wants to adjust his portfolio exposure. If he sends orders to the futures market, there may not be sufficient liquidity. If he sends orders to the cash market to buy or sell every stock that makes up his investment portfolio, he faces high costs, execution delays and the prospect of causing disorder to the cash market. The end result is that the overall market volatility will be higher, not lower," he explains.

"The sensible policy is to build liquidity and depth in both the cash and futures markets, as well as to increase stock index arbitrage efficiency to pool together liquidity from these markets. This is the best recipe for increasing market stability," he concludes.