Arbitrage opportunities in index futures

Abstract

With the advent of financial stock index futures contract in the early 1980s, the financial world has undergone a revolution. The stock index futures has since become the most widely traded financial instrument in the financial futures market. Corporate and individual investors, like banks, insurance companies, fund managers, pension funds and broking houses, find it useful for hedging, portfolio re-adjustment and arbitrage purposes. Its underlying potential has yet to be fully exploited. The objective of this thesis is to investigate the arbitrage opportunity inherent in this emerging star. Even since its introduction to the financial world, arbitrageurs have used it widely to capture riskless profit without any capital outlay or stocks on hand. However, no in -depth study has been done in this area. Thus, this empirical research is most timely. It will provide useful information to the financial industry as well as acting as a reference to varsity education and future research on this subject. To conduct this analysis, the Nikkei Index Futures traded in SIMEX and the Hang seng Index Futures of the Hong Kong Futures Exchange were selected. The period of study is 2.5 years for each contract and the data is categorised into the pre-crash and I the post-crash period with the October 19, 1987 stock crash as the divider. To enhance a better understanding of this instrument, a comprehensive literature review of the futures markets is covered in chapter 1 and 2. Areas like developments of futures markets, pricing and economic functions of index futures, are covered extensively. As the analysis is based on the Nikkei and Hang Seng Index Futures, a wide discussion on this two instruments is also included. The running of the tests is facilitated by using a computer program specially written for computing the theoretical stock index price based on the "cost-and-carry" model. The results, after dividing into pre-crash and post-crash periods, are analysed closely. After careful interpretation and analysis, a conclusion can be drawn that the discrepancies in the fair value and actual price did existed but diminished to a large extent after transaction costs was taken into consideration. However the mispricing patterns behave differently in the two contracts studied. The Nikkei Index Futures is usually negatively mispriced. This phenomenon is more significant in the post-crash period after transaction costs was included. On the other hand, the Hang Seng Index Futures is more inclined to positive mispricing, especially after transaction costs was taken into consideration.