Arbitrage in the FTSE 100 index futures

Abstract

This thesis presents five empirical papers investigating the issue of arbitrage trading of the FTSE 100 stock index futures. The first paper explores the effects of nonsynchronous trading on the spot index and develops a new technique as well as improving current methodologies for removing them. Studies in U. S. have shown that if the problem of non-synchronous trading is severe, the reported spot index is not reliable affecting the correct pricing of futures contracts. The second paper investigates the elasticity of supply of arbitrage in the futures market and the ability of the spot and the futures markets to respond to new information. It shows that arbitrage trading is initiated when spot prices largely drift apart from the futures prices. In addition, the futures prices tend to uncover new information before the spot prices, although this relationship is not stable over time. The analysis incorporates all possible channels of information to the -markets, which previous research fails to consider. The third paper analyses the behaviour of the deviation of the actual futures price from its theoretical value. Although this deviation is seen to have decreased its size over the years, it is still significant and persistent. Furthermore, it cannot be explained by the tax-timing option on pricing the futures or the effects of nonsynchronous trading. The fourth paper examines the presence, size and frequency of the profitability of the observed arbitrage opportunities by applying different transactions costs bounds to account for different classes of traders. After applying trading simulations arbitrage profitability is found to be frequent and significant, despite the fact that its size has decreased over the years. Finally, the thesis concludes with the fifth empirical paper which investigates the impact of futures trading on the spot and futures market volatility. It finds that arbitrage increases spot and futures price volatility but a volatile market brings the two markets closer on the whole, the thesis shows that although profitable arbitrage opportunities are not present in the long-run, they are not quickly removed in the short-run, allowing the spot and futures prices to drift apart.