Discretionary government intervention and the mispricing of index futures

Abstract

1160Draper and Fung 1 Naranjo and Nimalendran (2000) find that the Federal Reserve and the Bundesbank intervened in the dollar-mark market on 704 and 1,166 days, respectively, out of 4,723 trading days between January 1976 and December 1994. 2 The Taiwan government occasionally intervenes in the market through the operation of a stock market support fund. The interventions are of relatively small magnitude. the pricing relationship between the Hang Seng Index futures and the cash index during the period of the Asian financial crisis. The study avoids infrequent trading and nonexecution problems by using tradeable bid and offer quotes for the constituent stocks of the index. The results show that arbitrage efficiency was impeded during, and in the immediate aftermath of, the intervention. The findings suggest that discretionary government action introduces an additional risk factor for arbitrageurs that continues to disrupt normal market processes even after the government ceases to intervene. The continued disruption following the government's actions in the market also stems from a poorly developed stock loan market that impedes short selling, as well as a lack of liquidity in the market.

Order imbalance and the pricing of index futures

“…Studies of the Hang Seng Index contracts by Fung and Draper (1999), Fung andJiang (1999), andJiang, Fung, andCheng (2001) show that the lifting of restrictions against short-selling reduces the size and the frequency of discounts, and speeds up the dynamic adjustment process, especially when futures are underpriced. Draper and Fung (2003) find that a large negative basis in Hang Seng Index futures is associated with the lack of short-selling in the index constituent stocks following market intervention by the Hong Kong government. Cornell and French (1983) conjecture that the presence of a tax timing option in stocks induces a premium in the cash index over the futures.…”

“…Shleifer and Vishny (1997) show theoretically that widening of the arbitrage basis under extreme market conditions could paralyze arbitrage because of exhaustion of arbitrage capital. Draper and Fung (2003) examine the behavior of the arbitrage basis during the Hong Kong financial crisis, and find that the index and futures prices remained closely aligned until the Hong Kong government intervened in both the stock and the index derivatives markets. Yet Harris, Sofianos, and Shapiro (1994) find that program trading activities are positively related to market volatility.…”

“…When there is a large positive order imbalance in the index stocks, this indicates excess buying in the cash market; a large negative order imbalance indicates excess selling. 1 See for examples Sofianos (1993) and Neal (1996) for the U.S. markets; Yadav andPope (1990, 1994) for the U.K. markets; and Fung and Draper (1999) and Draper and Fung (2003) for the Hong Kong markets. Roll, Schwartz, and Subrahmanyam (2005) find that the absolute level of the index-futures basis is positively related to the illiquidity of the market.…”

“…Following Draper and Fung (2003), I attempt to address the problem by using bid and ask index prices that are estimated from synchronous and active stock quotes retrieved from a screen-based trading system. The quotes in the system are firm commitments, meaning the measured arbitrage opportunities are forward-looking and potentially executable.…”

Order Imbalance and the Dynamics of Index and Futures Prices

“…Harris (1989), Kleidon (1992) and Kleidon and Whaley (1992) have examined the large negative basis during the October 1987 U.S. market crash. Draper and Fung (2003) have examined the behavior of the arbitrage basis during the Hong Kong financial crisis and find that the index and futures price remained closely aligned until the Hong Kong government intervened in both the stock and index derivatives markets. On the other hand, Harris, Sofianos, and Shapiro (1990) find that program trading activities is positively related to market volatility.…”