Order imbalance and the pricing of index futures

Abstract

This study examines whether the direction and magnitude of the aggregate order-imbalance of the index stocks can explain the arbitrage spread between index futures and the underlying cash index. The data are for the Asian financial crisis period and hence entail wide variations in order imbalance and the index-futures basis. The analysis controls for realistic trading costs and actual dividend payments. The results indicate that the arbitrage spread is positively related to the aggregate order imbalance in the underlying index stocks; negative order-imbalance has a stronger impact than positive order imbalance.Violations of the upper no-arbitrage bound are related to positive order imbalance and violations of the lower no-arbitrage bound are related to negative order imbalance. Asymmetric response times to negative and positive spreads can be attributed to the difficulty, cost, and risk of short stock arbitrage when the futures is below its no-arbitrage value. The significant relationship between order imbalance and arbitrage spread confirm that index arbitrageurs are important providers of liquidity in the futures market when the stock market is in disequilibrium.

Order Imbalance and the Dynamics of Index and Futures Prices

“…Existence of real and persistent arbitrage opportunities, despite the abundance of astute and resourceful arbitrageurs, may imply that these are potential rewards to arbitrageurs for providing a unique financial service. Fung (2005) finds empirical support of Grossman's (1988) conjecture that arbitrage opportunities could be real and are potential compensations to arbitrageurs for providing liquidity in futures when trading is skewed toward one side of the market. In particular, he finds that the level and persistence of the arbitrage basis is related to stock market order imbalance.…”

“…These results indicate that the hurdle against short-selling impedes the short-stock long-futures arbitrage process when the futures is underpriced. Fung (2005) show that the arbitrage basis is positively related to (signed) order imbalance. In particular, large positive (negative) order imbalance is associated with large positive (negative) arbitrage basis.…”

“…Moreover, negative order imbalance in particular significantly increases the convergence time when the futures is underpriced. This study extends Fung (2005) and examines the impact of order imbalance on the dynamics of index and futures prices.…”

“…Following Fung (2005), it is expected that the cash index returns and order imbalance should bear a strong contemporaneous relationship. Moreover, since futures returns usually lead that of the cash index, futures returns should lead order imbalance.…”

“…This study extends Fung (2005) and examines how and to what extent stock market order imbalance affects the price dynamics of index and futures. In particular, the study examines the Hang Seng Index (HSI) and futures.…”