A Study of Arbitrage Efficiency Between the FTSE‐100 Index Futures and Options Contracts

Abstract

Despite the importance of the London markets and the significance of the relationship for market makers, little published research is available on arbitrage between the FTSE-100 Index futures and the FTSE-100 European index options contracts. This study uses the put-call-futures parity condition to throw light on the relationship between options and futures written against the FTSE Index. The arbitrage methodology adopted in this study avoids many of the problems that have affected prior research on the relationship between options or futures prices and the underlying index. The problems that arise from nonsynchroneity between options and futures prices are reduced by the matching of options and futures prices within narrow time intervals with time-stamped transaction data. This study allows for realistic trading and market-impact costs. The feasibility of strategies such as execute-and-hold and early unwinding is Index options (ESX) eliminate the possibility of early exercise in the option leg of the arbitrage portfolio.This study uses time-stamped bid-ask quotes and traded prices for both contracts. The data permit the matching of traded prices within narrow time intervals of 1 min. This reduces the nonsynchronous price problem. We allow for trading and market-impact costs, with market-impact costs determined from bid-ask quotes. The feasibility of execute-andhold and early-unwinding strategies is examined with ex-post and ex-ante simulation tests. This study also examines whether there is any significant intraday variation in the pattern of the distribution of mispricings. The ex-ante simulations allow for possible execution time lags in establishing each leg of the arbitrage trade. The relationship between arbitrage profit and spread costs, time to maturity, types of strategies adopted, and market volatility (as implied by the futures and options prices) is also examined.This study reveals that the occurrence of matched put-call-futures trios exhibits a U-shaped intraday pattern, with concentrations at both open and close. The magnitude of the observed mispricings, however, has no discernible intraday pattern. 4 This study finds ex-post arbitrage profits for traders facing transaction costs are limited and generally are rapidly extinguished in less than 3 min. Profits are larger the greater the spread, volatility, and time to maturity are, but the average ex-post profit is very close to the ex-ante profit for lags of less than 3 min. Long-futures trades are marginally more profitable than short-futures strategies. Early unwinding may also be profitable, but for traders facing even low levels of transaction costs, the number of opportunities is small.The results provide important confirmation for the results derived by Lee and Nayar (1993) and Fung and Chan (1994) for the Standard and Poor's (S&P) 500 and by Fung and Fung (1997a) for the Hong Kong Hang Seng Index. All three markets exhibit market efficiency and are consistent with the conclusions of Fleming, Ostdiek, and Whaley (1996), who found that traders p...

Cross‐market efficiency in the Indian derivatives market: A test of put–call parity

“…The mispricing is more frequent and higher in magnitude during the first and the last half-hour of a trading day. This finding is similar to that of Draper and Fung (2002), and may be caused by the anxiety of the traders near the opening and closing times. The put options are overpriced more often than the call options owing to the restrictions on short sales in the cash market.…”

“…The high value (24,378) of Kruskal-Wallis H-statistic and its insignificant p-value confirm the significant differences between the average mispricing for different volatility ranges. These findings are similar to those of Kamara and Miller (1995), Ackert and Tian (1999), and Draper and Fung (2002).…”

“…However, such opportunities are less frequent. These results are similar to those of Kamara and Miller (1995), Ackert and Tian (1999), and Draper and Fung (2002) for the U.S. and U.K. markets and support the argument advanced by Kamara and Miller. They argued that the factors affecting the PCP violations are proxies for the risk of inability to execute all the legs of an arbitrage at the right price, after the identification of the opportunity.…”

“…It may be owing to the anxiety of the traders to take up or liquidate specific positions near the opening and closing times. The pattern is similar to that observed by Draper and Fung (2002) for FTSE-100 at London International Financial Futures and Options Exchange.…”

“…Kamara and Miller (1995) for S&P 500 and Draper and Fung (2002) for FTSE-100 found the PCP violations to increase with the time to expiration. Ackert and Tian (1999), on the other hand, found the violations to decrease (increase) with the time to expiration for the short (long) strategy.…”