Index arbitrage with heterogeneous investors: A smooth transition error correction analysis |
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| Institution: | 1. Vertebrate Zoology Department, Saint Petersburg State University, Saint Petersburg 199034, Russia;2. Saint Petersburg State Academy of Veterinary Medicine, Saint Petersburg 196084, Russia;1. Institute for Biomedical Informatics, Departments of Genetics and Biostatistics and Epidemiology, Perelman School of Medicine, University of Pennsylvania, 3535 Market Street, Philadelphia, PA 19104, USA;2. Biomedical and Translational Informatics, Geisinger Health System, Danville, PA, USA;3. Department of Biochemistry and Molecular Biology, Center for Systems Genomics, Eberly College of Science, The Pennsylvania State University, University Park, PA, USA;1. Department of Finance, Asia University, Taiwan;2. Department of Finance, Ming Chuan University, Taiwan;3. Department of Shipping and Transportation Management, National Taiwan Ocean University, Taiwan;1. Economics Area, Indian Institute of Management Ahmedabad, Vastrapur, Ahmedabad, Gujarat 380015, India;2. Economics Area, Indian Institute of Management Udaipur, Balicha, Udaipur, Rajasthan 313001, India |
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| Abstract: | The traditional index arbitrage model assumes a constant threshold mispricing between the futures and cash prices for all investors. Allowing for heterogeneity in investors' transaction costs, objectives, and capital constraints, we model the intraday mispricing of DJIA futures as a smooth transition autoregressive (STAR) process with the speed of adjustment toward equilibrium varying directly with the mispricing. We show that the observed mean reversion in mispricing changes is induced by heterogeneous arbitrageurs, instead of a statistical illusion-infrequent trading of index portfolio stocks. We further use a STAR error correction model to describe the nonlinear dynamics between the DJIA futures and index. This model describes not only which market is more informationally efficient than the other, but also the legging process – the nonsimultaneous establishing of cash and futures positions. |
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