Academic journal article International Journal of Management

Effect of Market Imperfection on the Relationship between Future Index Prices and Spot Index Returns: An Empirical Study

Academic journal article International Journal of Management

Effect of Market Imperfection on the Relationship between Future Index Prices and Spot Index Returns: An Empirical Study

Article excerpt

The degree of market imperfections affects the pricing of financial assets and the dynamic relationship among financial instruments. To investigate the dynamic interrelationship between the expected growth rate implied by the prices of index futures and the rate of return of the underlying index spot, this study examines data from the S&P 500, Nikkei 225 index futures and the TAIFEX TAIEX index futures by using the vector autoregression (VAR) model, Granger causality test, and generalized impulse response function (GIRF). The empirical result shows that the dynamic interrelationship is weaker in the mature US and Japanese markets (which represent a more perfect market) than in the emerging Taiwanese market (which represents an imperfect market). Examining the relationship between future index prices and spot index returns is an effective way of investigating market imperfections and inefficiencies.

1. Introduction

The dynamic interrelationship between futures and spot markets, has been widely discussed in the past literature. However, the pricing model of stock index futures used to be under the perfect-market hypothesis. Wang and Hsu (2006a) demonstrate that, relative to the benchmark model of perfect-market assumption, futures contracts are more likely to be priced inaccurately in a market with larger market imperfections, suggesting that the impact of market imperfections on the pricing of stock index futures is tremendous. In a subsequent paper, Wang and Hsu (2006b) empirically test the Hsu and Wang's (2004) model and show that the model outperforms perfect-market models such as the cost of carry model and the Hemler and Longstaff (1991) model.

Wang and Hsu also recognize that it is not easy to estimate the price expectation (i.e., expected growth rate) owing to investors' sudden change of price expectation if new information arrives. Various techniques for estimating price expectation have been employed in recent literature. One estimation method is the implied expectation, which is similar to the implied volatility in the Black-Scholes (1973) model (for example, Schmalensee and Trippi, 1978). The second estimation method is the adaptive expectation model (for example, Nerlove, 1958; Wachtel and Figlewski, 1981). However, since there is no real data for price expectation, the effectiveness of these methods is difficult to evaluate.

The price of an index future and its underlying index spot will simultaneously reflect relevant information if financial markets are perfect. Because of market imperfections, the dynamic interrelationship between index futures and spot markets exists. For instance, in the futures market in which there are lower transaction costs and fewer trading restrictions, futures prices reflect relevant information more quickly than stock prices. Moreover, the more friction the markets have, the more obvious the dynamic interrelationship between the futures price and its underlying index should be. The greater the market imperfection, the more apparent the dynamic interrelationship between index futures and spot markets. Market imperfections vary in different markets of different countries, making their dynamic interrelationship unequal. Therefore, we can examine the efficiency and maturity of a market by testing the dynamic interrelationship between futures and spot markets in that market.

Hsu and Wang's (2004) pricing model of stock index futures in imperfect markets considers that market imperfections and incomplete arbitrage make price expectation enable to influence the price of stock index futures. Because the model can reasonably account for the pricing behavior of stock index futures, such as the phenomenon of negative bases, it has gradually attracted the attention from academic workers and practitioners. However, considering the difficulty in price expectation, we first bring the accurate estimations of dividend payouts for the USA, Japanese, and Taiwanese markets into this model to calculate the implied expected growth rate. …

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