Investigating the Pricing Efficiency of Indian Equity Futures Market

Abstract

The present study examines the arbitrage efficiency of the Indian equity futures market over the sample period June 2000 to December 2005. The results suggest that although stable and strong long-run relationship exists between futures and cash markets but futures show significant deviations from its cost-of-carry price, which offers exploitable arbitrage opportunities to the traders. Mispricing has been observed to be a direct function of time-to-maturity, stochastic behavior of interest rates, short sales restriction in the cash market, information asymmetry in both futures and cash markets and restricted exposure of institutional traders to the futures market. Moreover, basis shows significant mean reverting behavior, which indicates that early liquidation option as suggested by Neal (1996) may be helpful in improving the price discovery efficiency in futures as well as cash markets.

Impact Of Financial Crisis On Hedging Effectiveness Of Futures Contracts: Evidence From The National Stock Exchange Of India

“…OLS, ECM, VECM and M-GARCH, and their findings indicate that the M-GARCH model provides lower hedge ratios compared to other models, and captures time variation, thereby improving hedging performance at a lower cost. On the other hand, Gupta and Singh (2009) found that the hedge ratio estimated through VAR and VECM reduced the portfolio variance to the largest extent as compared to other methodologies, as the cash and futures market observes long-run comovement. However, Hatemi and Roca (2006) suggested that the use of the Kalman Filter approach for estimating the time-varying hedge ratio has been found to be more efficient.…”

“…Moreover, futures trading is not only popular in developed markets of the world, but is equally popular in emerging markets like India, which is evident from the fact that Indian equity futures consistently rank amongst the top five markets of the world for the last decade2. However, to the best of our knowledge, in the Indian context only a few attempts have been made to examine hedge effectiveness (Bhaduri and Durai, 2007;Rao and Thakur, 2008;Gupta andSingh, 2009 andPradhan, 2011) and these studies have primarily focused on examining a superior methodology for determining an optimal hedge ratio. Therefore, the present study is an attempt to shore this literature gap by examining the impact of the 2008 financial crisis on the hedging effectiveness of futures contracts, and also to study the relationship between hedging effectiveness, price trends and the time-to-maturity of equity futures contracts in India.…”

“…Working argued that the objective of hedging is not to minimize risk, but to maximize profits by speculating on basis. Thus, this theory suggests that a long hedger will hedge portfolio risk if the basis is expected to rise, whereas a short hedger will hedge if the basis is expected to fall (Gupta and Singh, 2009). While Working's theory proved to be an improvement over the naive-hedging theory, it suffers from an unrealistic assumption that hedgers can maximize their wealth at any level of risk.…”

“…However, it is a well-established fact that a financial time series observes time varying patterns, and that volatility clustering is their innate feature (Gupta and Singh, 2009). Hence, voluminous literature has found that time-varying hedge ratios are superior to constant hedge ratios (Myers, 1991;Park and Switzer, 1995;Aggarwal and Demaskey, 1997;Moschini and Myers, 2002;Harris and Shen, 2003;Pattarin and Ferretti, 2004;Kofman and McGlenchy, 2005;Floros and Vougas, 2006;Bhaduri and Durai, 2007;Yoder, 2007 andYang andLai, 2009).…”

“…However, Gupta and Singh (2009) also suggested that hedging through liquid futures contracts by estimating the long-run hedge ratio involves low hedging cost and provides flexibility to hedgers with respect to time-to-expiry. Similarly, Bhaduri and Durai (2007) compared the optimal hedge ratios estimated from four models, i.e.…”