This article tests a theoretical model of the basis and open interest of stock index futures. The model is based on the differences between stock and futures in terms of investors' ability to customize stock portfolios and liquidity. Empirical evidence confirms the model's prediction that increased volatility decreases the basis and increases open interest. School of Economics, and the University ofRhode Island for helpful comments, Paine-Webber for some of the data, and James Berens and Feng Zhang for research assistance. 281 282 The Journal of Finance attractiveness of portfolio tailoring and market liquidity to an investor, CV may be positive or negative. When making asset allocation adjustments, stocks can be traded selectively. Because of this, the CV associated with these trades can have a significant influence on the choice between trading stocks or futures, as well as on which stocks to trade. Diversified investors are likely to have an inventory of stock positions with differential and nonzero CVs. Suppose they choose to reduce their exposure in equities. By selling futures instead of stocks, they can keep the CV of their inventory intact as they reduce their equity exposure. Should the spread between the futures and cash prices be sufficient to justify stock trades, investors will maximize the CV of their remaining portfolio by selling the shares with the smallest CVs first. Therefore, as equity exposure is reduced, the marginal CV of portfolios increases.1 The marginal CV of portfolios should be reflected in the relative prices of stocks and index futures (up to arbitrage bound constraints). As the underlying volatility changes, risk-averse investors respond by adjusting their portfolios, affecting relative prices. In particular, as volatility increases, investors holding equity positions respond by selling stocks and futures. The CV of the marginal stocks in their portfolios increases; this is reflected in a higher equilibrium price of stocks relative to futures. New investors, entering the market to help bear the increased risk, purchase both stocks and futures; this increases the number of futures contracts outstanding (open interest). Both a formal model and empirical evidence in support of these hypotheses are presented in this article.Section I reviews the relevant literature. Section II presents the theoretical model and its predictions. Section III presents the empirical results, while Section IV concludes.
Corporate finance researchers have long been puzzled by low corporate debt ratiosgiven debt's corporate tax advantage. This article recognizes that firm value typically reflects a growing stream of earnings, while current debt reflects a nongrowing stream of interestpayments. Debt to value is therefore a distorted measure of corporate tax shielding. Even with very small debt-related costs, this may explain the observed magnitude and cross-sectional variation of debt ratios. Since this variation may be independent of tax shielding, debt ratios provide an inappropriate framework for empirically examining the trade-off theory of capital structure.The trade-off theory of capital structure argues that value-maximizing firms attain an optimal capital structure by balancing the corporate tax benefits of debt against the (personal tax, bankruptcy, or agency) costs associated with debt. Though widely utilized in corporate finance, the trade-off theory has been criticized on the basis that it is not adequately descriptive of observed capital structures Myers (198411. Even casual empiricism suggests that the trade-off theory is somewhat lacking: How can debt's marginal disadvantage be as great as its margina advantage when a typical firm has a debt ratio in the 25 to 30 percent range?
This article tests a theoretical model of the basis and open interest of stock index futures. The model is based on the differences between stock and futures in terms of investors' ability to customize stock portfolios and liquidity. Empirical evidence confirms the model's prediction that increased volatility decreases the basis and increases open interest.
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