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Order Imbalance and the Dynamics of Index and Futures Prices

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Author Info
Joseph K.W. Fung (Hong Kong Baptist University)
Philip Yu (University of Hong Kong)

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Abstract

This study uses transaction records of index futures and the index stocks, with bid/ask price quotes, to examine the impact of stock market order imbalance on the dynamic behavior of index futures and cash index prices. Spurious correlation in the index is purged by using an estimate of the "true" index with highly synchronous and active quotes of individual stocks. A smooth transition autoregressive errorcorrection model (STAECM) is used to describe the nonlinear dynamics of the index and futures prices. Order imbalance in the cash stock market is found to significantly affect the error-correction dynamics of index and futures prices. Order imbalance impedes error-correction particularly when the market impact of order imbalance works against the error-correction force of the cash index, explaining why real potential arbitrage opportunity may persist over some time. Incorporating order imbalance in the framework significantly improves its explanatory power. The findings indicate that a stock market microstructure that allows a quick resolution of order imbalance promotes dynamic arbitrage efficiency between futures and the underlying stocks.

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Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 072007.

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Length: 29 pages
Date of creation: Apr 2007
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Handle: RePEc:hkm:wpaper:072007

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  3. Cornell, Bradford & French, Kenneth R, 1983. " Taxes and the Pricing of Stock Index Futures," Journal of Finance, American Finance Association, vol. 38(3), pages 675-94, June. [Downloadable!] (restricted)
  4. Lease, Ronald C & Masulis, Ronald W & Page, John R, 1991. " An Investigation of Market Microstructure Impacts on Event Study Returns," Journal of Finance, American Finance Association, vol. 46(4), pages 1523-36, September. [Downloadable!] (restricted)
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  6. Joseph K. W. Fung & Li Jiang, 1999. "Restrictions on Short-Selling and Spot-Futures Dynamics," Journal of Business Finance & Accounting, Blackwell Publishing, vol. 26(1-2), pages 227-248. [Downloadable!] (restricted)
  7. Kleidon, Allan W & Whaley, Robert E, 1992. " One Market? Stocks, Futures, and Options during October 1987," Journal of Finance, American Finance Association, vol. 47(3), pages 851-77, July. [Downloadable!] (restricted)
  8. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March. [Downloadable!] (restricted)
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  12. Dwyer, Gerald P, Jr & Locke, Peter R & Yu, Wei, 1996. "Index Arbitrage and Nonlinear Dynamics between the S&P 500 Futures and Cash," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 9(1), pages 301-32. [Downloadable!] (restricted)
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  13. David Easley & Maureen O'Hara & P.S. Srinivas, 1998. "Option Volume and Stock Prices: Evidence on Where Informed Traders Trade," Journal of Finance, American Finance Association, vol. 53(2), pages 431-465, 04. [Downloadable!] (restricted)
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  15. Garbade, Kenneth D & Silber, William L, 1983. "Price Movements and Price Discovery in Futures and Cash Markets," The Review of Economics and Statistics, MIT Press, vol. 65(2), pages 289-97, May. [Downloadable!] (restricted)
  16. Miller, Merton H & Muthuswamy, Jayaram & Whaley, Robert E, 1994. " Mean Reversion of Standard & Poor's 500 Index Basis Changes: Arbitrage-Induced or Statistical Illusion?," Journal of Finance, American Finance Association, vol. 49(2), pages 479-513, June. [Downloadable!] (restricted)
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