Mispricing of index futures contracts: A study of index futures versus index options

The efficiency of derivatives markets is important not only to investors for speculation, hedging, and investment purposes, but also to regulators and society as a whole. Research has shown that there is mispricing in futures contracts relative to the cash market in different countries. In this article, we examine the parity relationship between futures and options contracts written on the Hang Seng Index (HSI). Both contracts are traded on the Hong Kong Futures Exchange (HKFE). These contracts eliminate a number of obstacles to index futures-index options arbitrage that have been proposed as reasons for mispricing in other markets, including uncertainty in future dividend payments, tracking error, and restrictions against short-selling of stocks. Furthermore, the tax timing option is minimal if not irrelevant in the Hong Kong market. The HSI options are all European, which removes early exercise as a problem. Even so, we find some mispricing, although not economically significant, during the period March 1993 to May 1995 after taking into account transaction costs, opportunity cost of margins, and differential borrowing and lending rates. The arbitrage profit is positively related to the time to maturity of the options and futures contracts and the volatility of the cash index. Buying the futures contract is more profitable than selling the futures contract. The profit is also higher when the options are farther away from the money.