Temporal Variation in Futures Mispricing

This paper explores the variation of pricing inefficiency of the stock and index futures with time. The theoretical ‘no arbitrage’⁄‘cost of carry’ price of futures contracts is compared with their actual prices for the period January 1, 2002 to November 24, 2004. The comparison has been made only for the near month futures to ensure good liquidity. In an efficient market, these two prices cannot differ because such a difference provides a risk-less arbitrage opportunity to market players. However, many instances of the difference between the two prices (mispricing) exceeding the transaction cost in the NIFTY index and stock futures are found for operators like financial institutions and members of derivatives exchange. This provides a clear arbitrage opportunity to these players. On an average, NSE members could have made arbitrage profits of 0.34 per cent after accounting for transaction costs on more than 37 per cent of trading days. Financial institutions could have made average arbitrage profits of 0.38 per cent on more than 12 per cent of trading days. The NIFTY index futures are persistently underpriced plausibly due to restrictions on short selling and the hedging activity of investors and fund managers. Most of the high-volume stock futures, on the other hand, are generally overpriced. The overpricing of stock futures points towards the speculative activity in the cash market in these scrips. These findings are generally in line with those in the other markets of the world where such inefficiencies and underpricing in stock index futures are also observed. However, the findings on stock futures are unique to this study because stock futures, being more recent entrants to the global derivatives market, have not been adequately researched. Non-parametric tests including the Kruskal-Wallis test (for more than two samples) and the Mann-Whitney test (for two samples) are used in this study due to non-normality conditions in the mispricing series. Conclusions about the time pattern of mispricing are drawn based on these tests. There is no discernible improvement or deterioration in the efficiency of pricing of futures over the last three years since the introduction of stock futures to the Indian market. The last week prior to expiry shows a significant reduction in mispricing for both the NIFTY and stock futures due to unwinding of trading positions. But, there is no significant difference in the mispricing pattern between individual days of the last week. This shows that the unwinding activity is uniformly spread over the week. Also, there is no discernible difference in the mispricing pattern between different days of the week across the period of study. These results have obvious implications for the arbitrageurs in the Indian futures market which are as follows: There are many sizeable arbitrage opportunities available to the traders who are willing to take a counterparty position opposite to the market demand. Such opportunities and their magnitude keep changing over time. An arbitrage opportunity is likely to go down in the last week before expiry. One cannot expect more such opportunities on a particular day of the week.