Chapter 10 Program trading and stock index arbitrage

This chapter describes the development of the market in stock-index futures. The theoretical relationship between the futures price on a stock-index contract and the current level of its underlying index are described along with how prices are kept in line by arbitrage. In describing how the arbitrage is actually done, a program trading is discussed and the cost of carry model is generalized in the chapter to include the effects of transactions costs and the possibility of unwinding an arbitrage trade early. Reviewing the literature on empirical tests of the pricing model, it is found that most analysts found apparent futures mispricing, both in the U.S. and in foreign markets. Mispricing tended to be larger at the outset and to diminish over time as arbitrageurs developed more efficient information and execution procedures, such as electronic transmission of computer-generated orders into the market. The chapter presents the arguments that trading in stock-index futures, and especially arbitrage against the underlying stocks, led to increased volatility in the stock market. Except for the Triple Witching Hour where the link between futures and the potential for sharp price changes in the underlying stock is clear, the claim that index futures destabilize the stock market is not supported.