An alternative approach to evaluating the agreement between financial markets

This research investigates that the price relationship between a stock index and its associated nearby futures markets can be explained by the cost-of-carry model using the concordance correlation (CC) coefficient in the US financial markets. The main purpose of this research is to confirm that the CC coefficient is an appropriate methodology to determine ex post arbitrage opportunities and to maximize ex ante arbitrage profits through the analysis of the price relationship derived from the cost-of-carry model. To increase the robustness of the results and to enable us to generalize our conclusions, this analysis is carried out in consideration of external uncertainty, including the marking-to-market procedure of futures contracts and the transaction cost on the stock index and its futures markets, under several assumptions related to the conditions of transactions. Examining transaction price data on the S&P 500 stock index and its futures markets shows that the CC coefficient gives a good result for ex ante arbitrage profits and is appropriate for analyzing the relationship between the observed stock index futures market price and its theoretical price derived from the cost-of-carry model.     

Index Options-Futures Arbitrage: A Comparative Study with Bid/Ask and Transaction Data

We can infer from bid/ask quotations and transaction prices that where options contracts are traded under a competitive open‐outcry market‐making system, the options and futures markets are dynamically efficient. Ex‐ante analysis shows that potential arbitrage opportunities disappear within five minutes. Transaction price data understate both the frequency and magnitude of arbitrage opportunities that are signaled by bid/ask quotes. Quotes stale fast, so opportunities are short‐lived and some of the arbitrage opportunities are deceptive. Nonetheless, the evidence suggests that bid/ask quotes provide valuable trading signals to arbitrageurs. Profitability from exploiting the quotes is negatively related to execution delay and execution risk.     

Stock index futures arbitrage in emerging markets: Polish evidence

The efficiency of the market for stock index futures and profitability of arbitrage for contracts on the Warsaw Stock Exchange Index WIG20 is studied in this paper. The Polish market has unique attributes: in a relatively short time the risk-free interest rate has decreased significantly, short sale cannot be used to construct an arbitrage position by institutional investors, and the dividends are small and paid in an irregular manner. Examining intraday transaction data shows that ex post and ex ante violations for short arbitrage reveal almost all properties of a mature market. Nonetheless, findings for long arbitrage indicate inefficiency of the market.     

Short Selling and Index Arbitrage Profitability: Evidence from the SGX MSCI and TAIFEX Taiwan Index Futures Markets

There are numerous impediments to market efficiency and index arbitrage in real capital markets, including the uptick rule on short selling, execution risk, market impact costs, regulatory barriers, and capital constraints. Adopting and relaxing the uptick restriction in the Taiwan stock market facilitated a study on whether adjustments in this restriction influence the efficiency and arbitrage of the Singapore Exchange Limited (SGX) and the Taiwan Futures Exchange (TAIFEX) index futures markets. This study examines the above issues using five-minute intraday transaction data and performs an ex post test of arbitrage, ex ante test of arbitrage, and regression analysis. Empirical results indicate that relaxing the uptick rule should improve market efficiency and facilitate long arbitrage, subsequently accelerating the adjustment to no-arbitrage bounds and helping to decrease ex post and ex ante mispricing and underpricing following the relaxation.     

Hedging Corporate Bonds

We examine Treasury bond and stock index futures, the swap curve and two types of hypothetical corporate bond assets as alternative hedging instruments for portfolios of corporate bonds. Conducting ex post and ex ante tests we find evidence that credit quality and maturity are important sources of basis risk when hedging corporate bonds whose credit rating are below triple A. We conclude that a new corporate hedging instrument may be useful for those wishing to hedge corporate bond portfolios provided that transaction costs are not too high relative to existing futures contracts.     

Futures Options and the Volatility of Futures Prices

Assuming nonstochastic interest rates, European futures options are shown to be European options written on a particular asset referred to as a futures bond. Consequently, standard option pricing results may be invoked and standard option pricing techniques may be employed in the case of European futures options. Additional arbitrage restrictions on American futures options are derived. The efficiency of a number of futures option markets is examined. Assuming that at-the-money American futures options are priced accurately by Black's European futures option pricing model, the relationship between market participants' ex ante assessment of futures price volatility and the term to maturity of the underlying futures contract is also investigated empirically.     

Pricing U.S. Dollar Index Futures Options: An Empirical Investigation

This paper develops a pricing model and empirically tests the pricing efficiency of options on the U.S. Dollar Index (USDX) futures contract. Empirical tests of the model indicate that the market consistently overprices these options relative to the derived model. This overpricing is more pronounced for out‐of‐the‐money options than for in‐the‐money options and more pronounced for put options than for call options. To validate the above results, delta neutral portfolios are created for one‐ and two‐day holding periods and consistently generate positive arbitrage profits, indicating that on average the market overprices the options on the USDX futures contracts.     

Ex Ante Hedging Effectiveness of UK Stock Index Futures Contracts: Evidence for the FTSE 100 and FTSE Mid 250 Contracts

Ex ante hedging effectiveness of the FTSE 100 and FTSE Mid 250 index futures contracts is examined for a range of portfolios, consisting of stock market indexes and professionally managed portfolios (investment trust companies). Previous studies which focused on ex post hedging performance using spot portfolios that mirror market indexes are shown to overstate the risk reduction potential of index futures. Although ex ante hedge ratios are found to be characterised by intertemporal instability, ex ante hedging performance of direct hedges and cross hedges approaches that of the ex post benchmark when hedge ratios are estimated using a sufficient window size.     

EARLY UNWINDING STRATEGY IN INDEX OPTIONS-FUTURES ARBITRAGE

We first re-examine buy-and-hold arbitrage strategies using both ex-post and ex-ante index options and futures data in Hong Kong. The results show that the arbitrage profit is not large enough to cover the transaction costs for both individual and institutional investors. Second, we find that, when an early unwinding strategy is employed, the arbitrage profit improves significantly under ex-post analysis but only improves slightly under ex-ante analysis. In addition, opportunities for same-day unwinding are limited. Finally, our regression results indicate the magnitude of the arbitrage profit is positively related to the volatility of the stock market.     

American futures options arbitrage: evidence from the Nikkei 225 options market

Previous studies have examined the profitability of European index options arbitrage. This paper adds to the literature by investigating the arbitrage profitability of American index options—the Nikkei 225 index futures options traded on the Singapore Stock Exchange (SGX). Using the real-time bid–ask prices, we find evidence of profitable arbitrage opportunities, while the frequency of observations violating no-arbitrage bounds and the magnitude of arbitrage profits decrease with the level of transaction costs. Our results have implications for the analysis of American options market efficiency. Failure to use bid–ask prices may lead to biased conclusions.     

Investment Decision Making with Derivative Securities

This paper examines strategies employing stock options, index options, index futures options, and index futures contracts in an effort to establish under what conditions a portfolio manager should diversify into these derivative assets. The results show that futures option call writing and put buying were dominated by third-order stochastic dominance when compared to similar index options. Thus, when covered call writing or protective put buying are being considered, index options appear to be the better choice.     

Arbitrage risk and market efficiency

This article explores arbitràge risk and models a testable hypothesis for studies in the treasury bill futures market efficiency. The modern mean-variance theory applied to a hedged arbitrage portfolio is used for the analysis. For a given expected arbitrage profit, we derive minimum variance arbitrage (MVA) conditions. A minimum variance arbitrage line (MVAL) is then derived to show the risk-return tradeoff for arbitrage. Market efficiency conditions are discussed by taking into account arbitrage risk along with bid-ask spreads. The analysis in this study helps explain the puzzle of inefficiencies in the T-bill futures market. Because refinancing and variation margin (due to marking-to-market) are required for arbitrage using futures trading in general, our ex ante arbitrage model using the case of T-bill futures can be applied to other futures markets.     

Measuring Pricing Inefficiencies Under Stressful Market Conditions

This study examines the mispricing and time between arbitrage trades of the Hong Kong Hang Seng index futures and index options contracts under various stressed market conditions. Ex‐ante trading profits and differences in time between trades across up and down as well as stressed and non‐stressed markets are used to measure how well the derivative markets perform under emotional distress. We find evidence of illiquidity in stressed and down markets. In stressful markets and down markets, liquidity suppliers are less likely to trade against the informed traders. This, in turn, leads to longer time between trades and higher arbitrage profits.     

Arbitraging American Gold Spot and Futures Options

This study empirically tests rational pricing conditions applicable to American gold spot and futures options. A number of ancillary pricing relations also are tested. Transactions data supplied by the Montreal Stock Exchange and the New York Commodity Exchange are used in these tests. Arbitrage trading strategies designed to exploit violations of these conditions also are provided. The results indicate potential intermarket inefficiency: a substantial number of violations of a condition applicable to call options are found, and most of these violations are sufficient in magnitude to cover the relevant transaction costs of arbitrage.     

Incentives and Endogenous Risk Taking: A Structural View on Hedge Fund Alphas

Hedge fund managers are subject to several nonlinear incentives: performance fee options (call); equity investors' redemption options (put); and prime broker contracts allowing for forced deleverage (put). The interaction of these option‐like incentives affects optimal leverage ex ante, depending on the distance of fund‐value from the high‐water mark. We study how these endogenous effects influence performance measures used in the literature. We show that reduced‐form measures that do not account for these features are subject to economically significant false discovery biases. The result is stronger for low‐quality funds. We propose an alternative structural methodology for conducting performance attribution in hedge funds.     

An ex ante analysis of put-call parity

The authors previously had extended the theoretical put-call parity models developed by Stoll (1969) and Merton (1973) to include a dividend term. Ex post tests of the models were generally consistent with market efficiency, but a sufficient number of hedges had high enough returns to warrant analysis of ex ante results. The purpose of this study was to construct hedges 5 and 15 minutes after they were initially identified as having an ex post return in excess of $20 per hedge. The results indicate that mispriced options adjust and that economic profit is sensitive to the level of transaction costs and unlikely even for member firms.     

Index Options: The Early Evidence

Index options became the most important traded contracts during their first year of existence. Two contracts, namely those on the S&P100 and the Major Markets Index, have a trading volume which typically surpasses the trading volume in all individual stock option contracts. In this paper, we examine the pricing of the options on the S&P100 and the Major Markets Index. Using intra-day prices, we find the options frequently violate the arbitrage boundary, put/call parity, and are substantially mispriced relative to theoretical values. Our results suggest that tests of option pricing models may be more difficult than previously realized due to nonsynchronous prices, even using “real-time” data from the exchanges.     

Examining the Equilibrium Relationship Between the Shanghai 50 Stock Index Futures and the Shanghai 50 ETF Options Markets

Based on the put-call-futures parity model, this article studies the equilibrium relationship between the Shanghai 50 stock index futures and the Shanghai 50 Exchange-Traded Fund (ETF) options markets by analyzing the arbitrage opportunities and profits between these two derivative markets. This article reveals that the cost spread, option volatility, days from the expiration date, moneyness of options, trading strategy, and policy factors all have a great impact on the arbitrage profits and opportunities. In addition, significant arbitrage profits and opportunities indicate violations of put-call-futures parity. Although no equilibrium relationship exists between the Shanghai 50 stock index futures and the Shanghai 50 ETF options markets, efficiency in these markets has gradually improved.     

Price discovery in spot and futures markets: a reconsideration

We reconsider the issue of price discovery in spot and futures markets. We use a threshold error correction model to allow for arbitrage opportunities to have an impact on the return dynamics. We estimate the model using quote midpoints, and we modify the model to account for time-varying transaction costs. We find that (a) the futures market leads in the process of price discovery and (b) the presence of arbitrage opportunities has a strong impact on the dynamics of the price discovery process.     

The volatility of temperature and pricing of weather derivatives

We propose an Ornstein–Uhlenbeck process with seasonal volatility to model the time dynamics of daily average temperatures. The model is fitted to approximately 45 years of daily observations recorded in Stockholm, one of the European cities for which there is a trade in weather futures and options on the Chicago Mercantile Exchange. Explicit pricing dynamics for futures contracts written on the number of heating/cooling degree-days (so-called HDD/CDD futures) and the cumulative average daily temperature (so-called CAT futures) are calculated, along with a discussion on how to evaluate call and put options with these futures as underlying.