A Transactions Data Test of Stock Index Futures Market Efficiency and Index Arbitrage Profitability

TLDR: In this article, the efficiency of the market for stock index futures and the profitability of index arbitrage for The Chicago Board of Trade's Major Market Index contracts were investigated and the results indicated that the size and frequency of boundary violations are substantially smaller than those reported by earlier studies and have declined sharply with time.

Abstract: This paper investigates the efficiency of the market for stock index futures and the profitability of index arbitrage for The Chicago Board of Trade's Major Market Index contracts. The spot value of the index is computed with transactions prices for the component shares of the index obtained from the Fitch database. The tests account for transaction costs, execution lags, and the uptick rule for short sales of stocks. Results indicate that the size and frequency of boundary violations are substantially smaller than those reported by earlier studies and have declined sharply with time. INDEX ARBITRAGE IS A strategy whereby institutions, brokerage houses, or other large investors seek to profit from the spread between prices in the spot and futures markets for stock indices. For example, an investor might purchase predetermined baskets of stocks on the floor of the New York Stock Exchange and simultaneously sell a related index futures contract on the floor of the Chicago Board of Trade, hoping to profit from the price differences on the two exchanges. Computer programs constantly monitor stock and futures prices and automatically execute buy and sell orders when it appears that a profit is possible. Stock index futures can be priced by a simple arbitrage argument. If the dividends paid by the underlying basket of shares and interest rates are nonstochastic, markets are perfect, and there are no taxes, the pricing equation is: