Dealer interaction and price discovery in futures markets

Floor traders in futures markets, acting as dealers, can form inferences about aggregate order flow and other dealers' trading, at least regarding price and possibly quantities. Dealers who are more active in the pit should be able to obtain more information from observing the order flow and thus play a greater role in price discovery in futures markets. Using high frequency transactions data for S&P 500 futures from 1996 to 2001, we investigate some characteristics of active floor traders, such as their revenues and trading directions, as well as aggregate market conditions. These active floor traders not only trade frequently, but also tend to trade together; i.e., they tend to buy or sell together at the same time.{09}The empirical evidence supports that both the aggregate order flow and the active dealers' price dispersions, measured as the quantity weighted price deviations from the average market price, are informative for floor traders. We utilize Hasbrouck's (1995) information share (IS) and Gonzalo-Granger's (1995) permanent/transitory (PT) decomposition to examine the price discovery process for futures floor traders. Both methodologies suggest that active dealers are price leaders to inactive dealers in futures markets.