Research Discussion Papers, Bank of Finland
No 4/2000:
Informed Trading, Short Sales Constraints and Futures' Pricing
Pekka Hietala, Esa Jokivuolle ()
and Yrjö Koskinen
Abstract: The purpose of this paper is to provide an explanation for
relative pricing of futures contracts with respect to underlying stocks
using a model incorporating short sales constraints and informational lags
between the two markets. In this model stocks and futures are perfect
substitutes, except for the fact that short sales are only allowed in
futures markets. The futures price is more informative than the stock
price, because the existence of short sales constraints in the stock market
prohibits trading in some states of the world. If an informed trader with
no initial endowment in stocks receives negative information about the
common future value of stocks and futures, he is only able to sell futures.
Uninformed traders also face a similar short sales constraint in the stock
market. As a result of the short sales constraint, the stock price is less
informative than the futures price even if the informed trader has received
positive information. Stocks can be under- and overpriced in comparison
with futures, provided that market makers in stocks and futures only
observe the order flow in the other market with a lag. Our theory implies
that: 1) the basis is positively associated with the contemporaneous
futures returns; 2) the basis is negatively associated with the
contemporaneous stock return; 3) futures returns lead stock returns; 4)
stock returns also lead futures returns, but to a lesser extent; and 5) the
trading volume in the stock market is positively associated with the
contemporaneous stock return. The model is tested using daily data from the
Finnish index futures markets. Finland provides a good environment for
testing our theory, since short sales were not allowed during the period
for which we have data (27 May 1988 - 31 May 1994). We find strong
empirical support for the implications of our theory.
Keywords: futures' market; short sales constraints; asymmetric information; (follow links to similar papers)
JEL-Codes: G13; G14; (follow links to similar papers)
32 pages, May 18, 2000
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