11-04-2014, 11:38 AM
Arbitrage Opportunities In Intraday Trading Between Futures, Options And Cash Markets – A Case Study On NSE India
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ABSTRACT
Price discrepancies, although at odds with mainstream finance, are persistent phenomena in
financial markets. These apparent mispricings lead to the presence of “arbitrageurs,”
who aim to exploit the resulting profit opportunities, but whose role remains controversial.
This p a p e r investigates the impact of the presence of arbitrageurs in I n d i a n financial
markets. An arbitrageur, indulging in costless, riskless arbitrage is shown to alleviate the
effects of position limits and improve the transfer of risk amongst investors. When the
arbitrageur behaves non-competitively, in that he takes into account the price impact of
his trades, he optimally limits the size of his positions due to his decreasing marginal
profits. The use of high-frequency data and the choice for a small unit time interval to measure
these lead-lag relations comes at the cost of some or many missing observations, causing
traditional estimators to either under or overestimate covariance and correlations. We use a
new estimator to estimate lead-lag relationships between the cash NSE (National Stock
Exchange of India) index, options and futures. We find that futures returns lead both options
and cash index returns by approximately 10 minutes.
INTRODUCTION
The relationship between stock index futures market and stock index market has
been subject of numerous empirical studies. A large part of them concentrate on
examining an opportunity of index arbitrage.
From the theoretical point of view,
existence of an arbitrage strategy violates assumptions of the efficiency of the market,
thus studies in this field have fundamental character.
In turn, brokerage houses,
mutual funds, large investors etc. seek profits from the spread between prices on the
spot and futures markets. Therefore for practitioners, the analysis of the magnitude
and frequency of mismatching of these prices is a subject of vital interest.
A central idea in modern finance is the law of one price. This states that in a
competitive market, if two assets are equivalent from the point of view of risk and return,
they should sell at the same price. If the price of the same asset is different in two
markets, there will be operators who will buy in the market where the asset sells cheap and
sell in the market where it is costly. This activity termed as arbitrage, involves the
simultaneous purchase and sale of the same or essentially similar security in two different
markets for advantageously different prices (Sharpe & Alexander 1990). The buying cheap
and selling expensive continues till prices in the two markets reach an equilibrium.
THEORY ON ARBITRAGE
To understand what makes for arbitrage, one need to distinguish between
three types of arbitrage. The first is pure arbitrage, where one has
have two
identical assets with different market prices at the same point in time and the prices will
converge at a given point in time in the future. This type of arbitrage is most likely to
occur in derivatives markets options and futures- and in some parts of the bond market.
The second is near arbitrage, where one has assets that have identical or almost
identical cash flows, trading at different prices, but there is no guarantee that the prices
will converge and there exist significant constraints on investors forcing them to do so.
The third is speculative arbitrage, which is really not arbitrage in the first place. Here,
investors take advantage of what they see
as mispriced and similar (though not
identical) assets, buying the cheaper one and selling the more expensive one. If they
are right, the difference should narrow over time, yielding profits.
DATA
The data used in this study were obtained from the NSE (National Stock
Exchange of India) and consist of a six-months and a five-months period. Which
comprises
intraday quotes and transactions for all index option series and all traded
futures contracts and every change in the cash index level for January 19 through July 16,
2004 and January 03 through June 17, 2005.
The value of the NSE stock index Nifty is a weighted average of the last transaction
prices of 50 stocks. It is updated after each reported transaction in one of the component
stocks. Both the NSE index futures and the NSE index options are on a monthly
expiration cycle. The index options are of the American type. The contract sizes for the
futures and the options are restricted to minimum 0.2 million rupees.