SSE/EFI Working Paper Series in Economics and Finance
No 366:
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
based on short sales constraints and informational lags between the two
markets. In this model stocks and futures are perfect substitutes, except
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 gets a
negative signal about the common future value of stocks and futures, she is
only able to sell futures. In addition uninformed traders also face 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 compared to futures, provided that market makers in
stocks and futures only observe with a lag the order flow in the other
market. 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 time that we have data (May 27, 1988 - May 31, 1994). We find
strong empirical support for our implications.
Keywords: futures pricing; lead-lag; short sales; informed trading; trading volume; (follow links to similar papers)
JEL-Codes: G13; G14; (follow links to similar papers)
34 pages, March 17, 2000
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