INDEX-FUTURES ARBITRAGE IN JAPAN

Y. Peter Chung, Jun-Koo Kang and S. Ghon Rhee

ABSTRACT
We examine the impact of the unique Japanese stock market microstructure on the pricing of stock index futures contracts. We use intraday transactions data for the Nikkei 225 Futures contracts in Osaka and the corresponding Nikkei 225 Index in Tokyo. Incorporating more realistic transaction-cost estimates and various institutional impediments in Japan, we nd that the time-varying liquidity of some component shares of the index in Tokyo represents the most critical impediment to intraday arbitrage and often causes futures prices in Osaka to deviate signicantly and persistently from their no-arbitrage boundary, especially for longer-lived contracts.

1. INTRODUCTION
In this paper, we examine the pricing of stock index futures and the protability of index-futures arbitrage in light of the unique stock market microstructure and various institutional impediments in Japan. Because we have access to the data only for the rst three-year period after the introduction of the Nikkei 225 Futures in Japan (September 1988 through September 1991), our analyses are limited to the impact of market microstructure features prevailing then in Japan on the price discovery process of stock index futures. The available historical data include the intraday transactions prices of the Nikkei 225 Futures contracts traded on the
The Japanese Finance: Corporate Finance and Capital Markets in Changing Japan International Finance Review, Volume 4, 173197 Copyright 2003 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3767/doi:10.1016/S1569-3767(03)04009-3

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Osaka Securities Exchange (OSE) and minute-by-minute quotes of the Nikkei 225 Index on the Tokyo Stock Exchange (TSE). Market microstructure in Japan is signicantly different from that in the U.S., where other global contracts are traded. There is growing evidence in the literature for the U.S. and other global markets that market microstructure signicantly affects securities pricing.1 There are numerous real-world impediments to arbitrage trading in Japan: high transaction costs, cash margin requirements in the futures market, no responsible market maker and relatively long execution lags in the stock market, occasional non-trading of index component stocks, and difculties in borrowing stocks for short sales, in addition to other traditional institutional impediments. The tests in this study attempt to closely approximate conditions in the Japanese stock and futures markets. We rst incorporate an accurate estimate of transaction costs associated with index arbitrage in Japan. We then investigate the ex ante protability of trading on apparent ex post mispricing in the context of difculties involved in index arbitrage in Japan. The purpose of this paper is, therefore, to understand the Japanese market microstructure, and demonstrate its impact on index futures pricing and intraday index arbitrage opportunities at the initial stage of developing the equity index futures market in Japan. We nd that the time-varying liquidity of some component shares of the index in Tokyo and subsequent disintegration of the stock and futures markets represent the most critical impediment to intraday arbitrage and often cause futures prices in Osaka to deviate signicantly and persistently from their no-arbitrage boundary, especially for longer-lived contracts. This nding is in sharp contrast to earlier studies for the U.S. markets. For example, Chung (1991), MacKinlay and Ramaswamy (1988), Neal (1990), and Stoll and Whaley (1986), among others, report that the execution lag in arbitrage trades, the transaction costs involved, the up-tick rule for short sales of stocks, and other trading mechanisms are the major impediments to index arbitrage in the U.S. market. When arbitrageurs nd that it is difcult or even impossible to purchase or borrow some component shares of the index, arbitrage pressure breaks down in the absence of close substitutes. Consequently, the two markets are less integrated, and the index futures prices can at times deviate signicantly from the no-arbitrage boundary, and the deviations can persist. We provide evidence that the stock market turnover/liquidity and associated staleness of the index have signicant impacts on the estimated boundary violations by Nikkei 225 Futures prices. We demonstrate that, if the time-varying liquidity of Nikkei 225 stocks is ignored, spurious conclusions about the market efciency and the relation between the futures and cash markets can be obtained and arbitrage opportunities in Japan can be falsely identied. Thus, our results complement the importance attached to market microstructure in the literature.

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In Section 2, we describe the Nikkei 225 Index of the TSE and the corresponding Nikkei 225 Futures contracts traded on the OSE. We also discuss the transaction cost structure in Japan. In Section 3, we discuss the data. In Section 4, we document the extent to which the NSA futures are mispriced. In Section 5, we discuss the various aspects of the Japanese market microstructure and tests whether they can explain the occasional surges in the estimated mispricing of the Nikkei 225 futures documented in Section 4. Finally, we summarize and conclude the paper in Section 5.

2. INSTITUTIONAL BACKGROUND
2.1. Nikkei 225 Index and Nikkei 225 Futures Contracts The Nikkei 225 Index is the most widely quoted barometer of the Japanese stock market, and is the basis of the most popular futures contracts in Japan in terms of daily average volume and open interest. Many Japanese index funds track the Nikkei 225 Index, just as the Standard and Poors (S&P) 500 is heavily used by the U.S. index funds. The Nikkei 225 Index is a price-weighted index of 225 stocks listed in the rst section of the TSE.2 Futures contracts written on the Nikkei 225 Index have been also traded abroad on Singapore Exchange (SGX, formerly Singapore International Monetary Exchange (SIMEX)) since September 3, 1986. After the introduction of new Nikkei 225 Futures contracts in Japan on September 3, 1988, however, the offshore trading of Nikkei 225 Futures contracts on the SGX became much less active. In contrast, the trading volume in Osaka picked up sharply and soon passed the volume on the SGX. In 1991, the most recent sample year in our study, the daily average trading value in Singapore was a relatively modest amount of 37 billion or 1.7% of that in Osaka ( 2,182 billion). The Chicago Mercantile Exchange has also traded the Nikkei 225 Futures contracts since September 25, 1990, but their daily average trading volume is 850 contracts in 1991 or less than 1% of that in Osaka (87,980 contracts). As for the source of the Nikkei 225 Futures trading volume, about 5060% of trading volume is from domestic brokers, about 67% from foreign brokers, and about 30% from institutional investors such as banks, investment trusts, business corporations, and insurance companies during the three-year study period. Less than 1% of trading volume comes from individual investors. Japanese and foreign brokerage houses use the Nikkei 225 Futures contracts for their trading strategies; i.e. index arbitrage, portfolio insurance, or horizontal spreading.

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2.2. Transaction Cost Structure for Index Arbitrage in Japan The actual yen value of the portfolio of 225 stocks, holding one share in each stock, is the index multiplied by the index divisor, which is around 10 during our sample period. The value of one Nikkei 225 Futures contract is 100 times the total value of this stock portfolio, as the size of the futures contract is 1,000 times the Nikkei 225 Index. For a practical portfolio of 1,000 shares in each stock, the value of the futures contract would be only about one-tenth of the portfolios value. For arbitrage, an investor buying a round lot of each of the Nikkei 225 Index component stocks would therefore have to purchase about 10 Nikkei 225 Futures contracts on average. In this paper, our transaction-cost estimates use this scenario as a benchmark. There are seven components of transaction costs involved in the Nikkei 225 Index arbitrage in Japan. They include: (1) round-trip stock brokerage commissions to buy and sell the stocks on the TSE; (2) securities transfer tax paid when stocks are sold; (3) two market-impact costs on the TSE3 ; (4) one futures brokerage commission to open a position on the OSE; (5) one market-impact cost on the OSE; (6) cost of borrowing stocks for short arbitrage;4 and (7) interest lost on cash margin deposits for the futures position on the OSE. Appendix A presents the details of the transaction costs for two different types of arbitrage traders (brokers vs. institutional investors) and two different types of arbitrage trades (short vs long arbitrage).5 To get the total transaction costs as a percentage of the underlying index value, we add the three unusual items (2, 6, and 7) to the other four traditional items. For a typical long arbitrage, it would be realistic to estimate the total transaction costs to be 0.841% (0.781% after April 1, 1989) for brokers and 2.956% (2.706% after April 1, 1989) for institutional investors, plus interest lost on cash margin deposits. Transaction costs are 0.1% higher for a typical short arbitrage.6

3. DATA
Stock index futures can be priced by a simple arbitrage argument. If the dividends paid by the underlying stocks and interest rates are non-stochastic, markets are perfect, and there are no taxes, the pricing equation is: F (t , T ) = S (t )er (T t ) D (t , T ), (1)

where F(t, T ) equals the futures price at time t for a contract that matures at time T; S(t) equals the spot index value at time t; D(t, T ) equals the time T value of

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dividends paid on the component stocks between t and T; and r (T t ) equals the risk-free interest rate spanning the period from t to T.7 Actual Nikkei 225 Futures transaction prices on the OSE are obtained from data tapes provided by the Daiwa Institute of Research, Ltd. These transactions data record futures prices at which trades occurred to the nearest minute. The spot Nikkei 225 Index quotes announced at one-minute intervals by the TSE are obtained from the same tapes.8 Since there is no Gensaki rate for a maturity that exactly matches the maturity of the futures contract each trading day, one-, two-, and threemonth Gensaki rates are obtained from the Pacic-Basin Capital Market (PACAP) Databases and interpolated to compute the risk-free interest rates: The Gensaki (repo) rates are commonly used in Japan during the study period as Treasury-bill rates are in the U.S. The individual stock dividend data (actual amounts and ex-dividend dates) are obtained also from the PACAP Databases.9 The actual dividends subsequently realized over the life of the contract are used as a proxy for the expected dividend to be paid on the Nikkei 225 Index. The deferred value of dividends, D(t, T ) in Eq. (1), is computed using the Gensaki rates. This is an approximation that may not equal the markets anticipation of future dividends. Discrepancies caused by this approximation of dividends are likely to be small, as dividends are fairly predictable and stable in Japan.

4. EX POST MISPRICINGS OF NIKKEI 225 FUTURES

4.1. Frequency and Persistence of Ex Post Violations of No-Arbitrage Boundaries by Nikkei 225 Futures Prices To investigate rst the extent to which Nikkei 225 Futures are mispriced, the theoretical futures price is computed using Eq. (1) and is compared to the actual market price on a trade-by-trade basis within a day. For the ex post test, the hypothesis is: xp = |F (t , T ) S (t )er (T t ) + D (t , T )| b (t ) 0, F (t, (2)

where T ) is the actual futures price and b(t) is the present value of the sum of transaction costs for arbitrage. Let F (t , T ) S (t )er (T t ) + D (t , T ) equal v . A simple trading strategy that would prot from a mispriced futures contract that does not satisfy Eq. (2) consists of selling an Nikkei 225 Futures contract, buying the underlying Nikkei 225 Index component stocks, and holding this position until T if v is positive and v b (t ) is positive. If v is negative and |v | b (t ) is positive, then the strategy would be to sell short the underlying index stocks and buy the

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futures contract. In either case, the net prot from the arbitrage would be a positive xp , because the futures price would converge to the spot index value at T.10 In Panel A of Table 1, we report the frequency and average size of ex post violations of futures price boundaries for the most heavily traded, nearest maturity Nikkei 225 Futures contracts. It appears that mispricings are very frequent for brokers, who pay relatively lower transaction costs, with a few large surges to about 4058% (March 1989, June 1990, and March 1991 contracts), though about 26% on average. In contrast, ex post mispricing and subsequent index arbitrage opportunities are rare for institutional investors, whose transaction costs are much higher. Among twelve contract maturities examined, a signicant percentage of mispricings (2.4%) occurs only for the June 1990 contracts.11 It is noteworthy that mispricings, though frequent, are in most cases small: the average size of mispricings is 119.8 index points during our sample period, which represents the rst three years of Nikkei 225 Futures contract trading on the OSE. It is about 0.41% deviation from the no-arbitrage cost-of-carry price with transaction costs considered.12 To examine the persistence of mispricings, we also compute the average number of subsequent violations that follow each observed ex post violation.

Table 1. Frequency and Size of Ex Post and Ex Ante Violations of Futures Price Boundaries of Nikkei 225 Futures Contracts.a
Panel A: Ex Post Violations Contract Number of Obs. Trader Typea Frequencyb of Ex Post Violations 13900 (53.2%) 7686 (24.3%) 801 (2.0%) 6320 (16.5%) 10226 (15.8%) 50601 (57.7%) 2118 (2.4%) 18210 (19.6%) 9320 (18.2%) 39 (0.1%) 32494 (39.9%) 33724 (26.8%) 8 (0.0%) 26024 (18.7%) 212684 (26.2%) 2165 (0.3%) Sizec of Ex Post Violations 87.0 (0.3%) 358.1 (1.1%) 19.6 (0.1%) 248.4 (0.7%) 66.2 (0.2%) 194.0 (0.6%) 76.1 (0.2%) 34.2 (0.1%) 96.3 (0.4%) 62.7 (0.3%) 36.9 (0.2%) 175.0 (0.6%) 5.1(0.0%) 23.6 (0.1%) 119.8 (0.4%) 75.6 (0.2%)

Mar 89 Jun 89 Sep 89 Dec 89 Mar 90 Jun 90 Sep 90 Dec 90 Mar 91 Jun 91 Sep 91 Overall

26143 31669 40270 38391 64737 87771 92779 51338 81401 26071 39233 811991

Broker Broker Broker Broker Broker Broker I. inv. Broker Broker I. inv. Broker Broker I. inv. Broker Broker I. inv.

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Table 1. (Continued )
Panel B: Ex Ante Violations 5-Min Execution Lag Number of Tradesd Size of Arbitrage Prots 84.8 (0.3%) 356.4 (1.1%) 12.5 (0.0%) 245.0 (0.7%) 49.3 (0.1%) 187.6 (0.6%) 62.9 (0.2%) 12.9 (0.0%) 71.3 (0.3%) 90.0 (0.4%) 24.0 (0.1%) 167.4 (0.6%) 101.0 (0.4%) 3.3 (0.0%) 108.1 (0.4%) 62.5 (0.2%) 10-Min Execution Lag Number of Trades Size of Arbitage Prots 83.3(0.3%) 356.7 (1.1%) 30.9 (0.1%) 245.9 ( 0.7%) 43.4 (0.1%) 184.1 (0.6%) 51.6 (0.2%) 0.8 (0.0%) 60.0 (0.3%) 0.3 (0.0%) 18.0 (0.1%) 165.7 (0.6%) 128.2 (0.5%) 7.8 (0.0%) 103.4 (0.3%) 50.3 (0.2%) 15-Min Execution Lag Number of Trades Size of Arbitage Prots 83.8 ( 0.3%) 356.1 ( 1.1%) 35.3 (0.1%) 245.8 (0.7%) 42.8 (0.1%) 181.1 (0.6%) 44.1 (0.1%) 6.0 (0.0%) 55.8 (0.2%) 31.1 (0.1%) 17.6 (0.1%) 165.7 (0.6%) 95.0 (0.4%) 12.1 (0.1%) 101.2 (0.3%) 42.6 (0.1%)

12982 7292 718 5907 9597 48193 1994 17014 8404 23 30806 32042 8 24814 200801 2025

12354 6913 660 5623 9187 46224 1902 16042 7875 21 29389 30441 8 2373 19134 1931

11666 6580 592 5312 8736 44030 1776 14977 7633 21 28174 28646 8 22924 182005 1805

Note: Hypothesis for ex post violations: xp = |F (t , T ) S (t )er (T t ) + D (t , T )| b (t ) 0 where F (t, T ) is the actual futures price at time t for a contract that matures at time T; S(t) is the ex post index value at t; b(t) is the present value of the sum of transaction costs at t; D(t, T ) is the time T value of dividends paid on component stocks between t and T; and r(Tt) is the risk-free interest rate spanning the period from t to T. Ex post violations mean that traders can make positive prots assuming that they can execute orders at the observed index quote and futures price, both adjusted for bid-ask spreads. Hypothesis for ex ante violations: xa = F (t + , T ) S (t + )er (T t ) + D (t , T ) b (t + ) 0 if futures contracts are overpriced at t, or [F (t + , T ) S (t + )er (T t ) + D (t , T )] b (t + ) 0 otherwise, where F (t+ , T ) is the actual futures price at time t+ for a contract that matures at time T; S(t+ ) is the ex ante index value at t+ ; and b(t+ ) is the time t+ present value of the sum of transaction costs. Ex ante violations represent the ex ante arbitrage prots at t+ (xa ) triggered by mispricing signals (xp ) assuming that traders can execute their orders at the next index quote and the next available futures price following an execution lag after they observe mispricing signals. Sample period is September 9, 1988 to September 12, 1991. a For our estimates of transaction costs, see Appendix A. We report results for institutional investors (I. Inv.) only for contracts for which ex post mispricings are observed. b The percentage out of total number of observations is reported in parentheses. c In terms of index points: a full index point is equivalent to 1,000 per contract. The percentage deviation from the no-arbitrage cost-of-carry price (with transaction costs considered) is reported in parentheses. d The number of executable trades are signicantly less than comparable frequencies of ex post violations because some trades cannot be executed within the same day the violations occur, due to the execution lag.

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Persistent violations, especially if present on an intraday basis, can be evidence of underestimated transaction costs, impediment to arbitrage, or noise. We nd that mispricings are clustered and persistent.13 The persistence has not signicantly changed over the sample years. It implies that the serious clustering or persistence of ex post violations was not due to pure noise. Also, as suggested earlier, it does not appear to be due to underestimated transaction costs either.

4.2. Relation Between Mispricings and the Longevity of Nikkei 225 Futures Contracts Mispricings documented in Table 1 can be due to hidden costs or impediments associated with arbitrage. Arbitrageurs may face some costs that are not easily quantiable, and presumably those costs are positively related to the longevity of futures contracts, as discussed in MacKinlay and Ramaswamy (1988). To investigate whether there exists an observable systematic relation between mispricings and the days to maturity of Nikkei 225 Futures contracts, we stratify the observed ex post mispricings by days to maturity of futures contracts. Results indicate that the size and frequency of mispricings monotonically increase with longer-lived contracts.14 For example, the average size of mispricings for days to maturity of 119 days is 29.2 index points (or 0.11% from the no-arbitrage boundary with transaction costs), whereas it is 212.6 index points (or 0.72%) for the 80 days or longer group. Further, more than 85% (181,749 out of 212,684) of all the mispricings during our sample period occur for contracts that have at least 40 days prior to expiration. Figure 1 depicts the time-series behavior of the daily average size of ex post mispricings for our sample of 751 trading days. It shows that there are occasional but big surges in the estimated mispricings. Interestingly, those days with large mispricings closely match the earlier trading days of the new contracts.

5. EXPLANATIONS FOR OCCASIONALLY LARGE AND CLUSTERED MISPRICINGS OF NIKKEI 225 FUTURES
Why are the estimated mispricings clustered and persistent with a few big surges, especially for longer-lived contracts, even after the Nikkei 225 Futures market went through its infant stage? In this section, we attempt to provide some answers for this question. In doing so, we discuss the Japanese stock market microstructure in Tokyo and its potential impacts on index arbitrage. Our primary goal is to test

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whether it can explain the puzzling big surges in estimated mispricing of the Nikkei 225 Futures contracts in Osaka.

5.1. Execution Lag: Ex Ante Tests Ex post tests in the previous section assume instantaneous execution of stockfutures arbitrage trades, and they may overstate the prots of index arbitrage, because traders are not guaranteed execution of their orders at the observed prices. Ex ante tests allowing a reasonable execution lag should be used instead. Accordingly, our hypothesis is now different:15 xa = F (t + , T ) S (t + )er (T t ) + D (t, T ) b(t + ) 0 xa = [F (t + , T ) S (t + )er (T t ) + D (t, T )] b(t + ) if v is positive, or if v is negative (3) where F (t+ , T ) is the rst actual futures price following an execution lag after t, S(t+ ) represents the ex ante index value at t+ following an execution lag, b(t+ ) is the time t+ present value of the sum of transaction costs incurred in the arbitrage, and xa is, therefore, the ex ante arbitrage prot at t+ , triggered by a mispricing signal (a positive xp ) at t. It is assumed that traders can use 100% of short-sale proceeds and can borrow stocks for short sale. Also, traders are assumed to be able to borrow or lend money at the riskless Gensaki rate. The TSE, where the component shares of the index are traded, is a purely orderdriven, computerized auction market without any responsible market-maker or specialist. Instead, Saitori members maintain a central order book for each of their franchise stocks allocated by the exchange, and they match orders in accordance with price priority and time preference (see Lehmann & Modest, 1994, for more details). Thus, there is no guarantee that orders will be executed in a reasonably short period of time, which means more risk for arbitrageurs. Third, one important requirement for index arbitrage is quick execution of stock baskets. In the New York Stock Exchange (NYSE), a 200-stock basket takes less than ve minutes to execute through Super-Dot. This capability does not yet exist on the TSE.16 Five minutes is a conservative estimate by Japanese practitioners of the minimum time lag between the observance of mispricing signals and the execution of orders simultaneously in the stock and the futures markets. Since speedy execution capabilities do not yet exist on the TSE, even the ve-minute lag may overestimate the speed of execution on the TSE. Our ex ante tests are repeated for a range of alternative execution lags. In Panel B of Table 1, we summarize ex ante violations by Nikkei 225 Futures prices, assuming that traders can execute their orders at the rst available futures 0

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and spot index prices at least ve, ten, or fteen minutes after they observe ex post mispricings. Some notable points emerge. First, the numbers of executable trades are signicantly (614%) less than comparable frequencies of ex post violations in the same table, obviously because some trades cannot be executed within the same day the violations occur, due to the execution lag. Thus, ex post tests in the previous section signicantly overestimate the frequency of intraday arbitrage opportunities. Second, there are substantial differences between the size of the ex post mispricing and the realized prot on the resulting ex ante trade, especially for the more recent contracts (September 1990, December 1990, March 1991, and September 1991 contracts) with the exception of the June 1991 contracts. For example, the most recent September 1991 contracts violate the ex post no-arbitrage boundary 26,024 times, with an average mispricing of 23.6 index points. The corresponding ex ante arbitrage prots are on average 3.3 index points with a ve minute lag, 7.8 index points with a ten minute lag, and 12.1 index points with a fteen minute lag. This implies that the Nikkei 225 Futures contract prices in Osaka have recently tended to respond to ex post mispricings quickly enough to eliminate prot opportunities again, with the exception of a few contract maturities. Nevertheless, our major question still remains unanswered. Ex ante tests, although they substantially improve the picture of the Nikkei 225 Futures market efciency, cannot solve the puzzling surges in estimated ex post mispricings.

5.2. Difculties in Short Sales of Index Stocks Even though short sales (Kara-Uri) are permitted and there is no uptick rule in the TSE, short sales are very difcult in practice, making short arbitrage more costly.17 Share lending (Kashi-Kabu) is a huge business in Japan.18 Big Japanese institutions, such as life insurance companies and trust banks, earn a fee of up to 11.5%, though 0.1% on the average, of the market value of the shares they lend to brokers. Furthermore, the lender institution often demands back the shares it had already lent, so that brokers are forced to buy shares in the market prematurely in order to cover their short positions. To investigate whether difculties related to short sale of stocks can be responsible for occasional big surges in mispricing of futures contracts, we examine the average size and the frequency of observed ex post mispricings, and the resulting ex ante arbitrage prots, separately for long and short arbitrages. We merely mention the results in passing, as they are not strikingly different. First, the mean and the standard deviation of ex ante prots from executable short arbitrages are about the same as those from comparable long arbitrages.

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Furthermore, only 3.4% of all ex post violations (7,271 out of 212,684) are signals for short arbitrage for brokers. In brief, difculties in short sales of stocks do not seem to be a major reason for our puzzle.19,20

5.3. Nikkei 225 Index Component Stocks Spot Market Turnover/Liquidity in Tokyo So far, it appears that the Nikkei 225 Futures prices on the OSE do not experience a rather smooth learning curve. We, therefore, propose and test one explanation for this puzzle. The Japanese stock market is in many respects much less liquid than its U.S. counterpart. Buying (short selling) the Nikkei 225 Index component stocks, for example, means bidding for (borrowing) closely held shares, a nearly impossible task at times. Furthermore, liquidity of some Nikkei 225 Index component shares varies greatly over time. During our sample period of 751 trading days, 48 (15) Nikkei 225 Index component stocks experienced at least one (four) zero-turnover trading day while 102 trading days experience zero-turnover for at least one component share. Appendix B lists the forty-eight stocks that experience at least one zero-turnover day along with their industry classications. For the U.S. market, Harris (1989a) documents the impact of the liquidity of index stocks on the basis (i.e. the difference between the underlying index value and the futures price) for a ten-day period surrounding the October 1987 stock market crash. One can argue that the time-varying liquidity of index stocks can be a signicant factor for the pricing of index futures even in the U.S. market. To address this issue, we examine the Wall Street Journal, S&P Stock Guide, S&P 500 Information Bulletin, and Report of the Presidential Task Force on Market Mechanisms (1988), for October 1987, the most likely month with liquidity problems. We also poll a few exchange specialists. It appears that none of the S&P 500 stocks experienced non-trading on any trading day in October 1987. Of course, for some stocks, trading was thin, opening was delayed due to order imbalances, trading was at times suspended, and it may have taken unusually long before traders could buy or sell some of the S&P 500 stocks, but it was not impossible. Thus, the magnitude of the time-varying liquidity problem in the U.S. stock market, even during an exceptional period, is quite different from that in the Japanese market, where the non-synchronous trading problem is greatest due to (unpredictable) non-trading, not thin trading, of index component stocks. In order to provide distribution-free results on the relationship between the turnover/liquidity of component shares of the Nikkei 225 Index and mispricings of

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Table 2. Spot Market Turnover/Liquidity on the Tokyo Stock Exchange and Size and Frequency of Ex Post Boundary Violations of Nikkei 225 Futures Contracts.
Panel A: Distributions of Daily NSA Spot Market Turnover/Liquidity and Ex Post Boundary Violations by NSA Futures Prices Variable TONUMBER TO (%) NZEROTOa NLOWTO VIOSIZEb VIOFREQc Obs. 751 751 102 751 751 751 Mean 389940000 0.00242 1.84 170.06 39.33 23.15 Median 307970000 0.001866 1 179 6.33 1.48 Std. Dev. 278720000 0.001745 1.79 37.42 88.94 34.97 Min. 87433288 0.000514 1 28 0 0 Max. 2051916302 0.013328 8 222 675.54 100

Panel B: Non-parametric Correlations Between NSA Spot Market Turnover/Liquidity and Ex Post Boundary Violations by NSA Futures Pricesd TONUMBER VIOSIZE VIOFREQ 0.167 (0.0001) 0.188 (0.0001) TO (%) 0.175 (0.0001) 0.195 (0.0001) NZEROTOe 0.204 (0.0397) 0.201 (0.0424) NLOWTO 0.112 (0.0021) 0.131 (0.0030)

Note: Four measures of the spot market turnover/liquidity are used. TONUMBER is the daily number of shares traded for all 225 component stocks of the NSA; TO % is TONUMBER divided by the total number of daily outstanding shares for the 225 stocks; NZEROTO represents the daily number of NSA stocks whose turnover is zero; and NLOWTO represents the daily number of NSA stocks whose turnover is lower than its own time series average for the sample period. VIOFREQ and VIOSIZE represent the daily frequency and the daily average size of boundary violations by NSA index futures prices, respectively. Sample period is from September 9, 1988 to September 12, 1991. a Forty-eight (fteen) stocks experience at least one (four) zero-turnover trading day. b In terms of index points: a full index point is equivalent to 1,000 per contract. c The percentage out of daily number of observations. d The reported test statistic is the Spearmans rank correlation with p-values in parentheses. e Correlation between NZEROTO and VIOSIZE (or VIOFREQ) is calculated using only those 102 trading days for which at least one index component share is not traded at all.

the Nikkei 225 Futures, we report in Table 2 estimates of Spearmans rank correlation coefcients. Four alternative measures of the stock market turnover/liquidity are used. The rst one (TONUMBER) is the daily number of shares traded for all Nikkei 225 Index component stocks. The second one (TO%) is TONUMBER divided by the total number of daily outstanding shares for all 225 stocks. The third one (NZEROTO) represents the daily number of NSA stocks whose turnover is zero. The last one (NLOWTO) represents the daily number of NSA stocks whose turnover is lower than its own time-series average for the sample period.

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Results suggest that the Nikkei 225 Index spot market turnover/liquidity is signicantly related to boundary violations by Nikkei 225 Futures prices. There are signicant negative correlations between the measures of stock market turnover (TONUMBER or TO%) and the daily average size (VIOSIZE) and the daily frequency (VIOFREQ) of boundary violations. The correlation is signicantly positive when NZEROTO or NLOWTO is used instead as a measure of spot market turnover/liquidity. This is an interesting nding in the following sense: When one component share of the index is not traded at all on the TSE, the arbitrage link between the stock and the futures markets does not exist and subsequent mispricings occur and persist because traders cannot execute their arbitrage trade orders in the stock market.21 This problem becomes more serious as the number of non-traded (or thinly-traded) shares increases, as evidenced in Table 2. Still, the TSE reports an index value that is seriously stale. Thus, frequent and clustered mispricings of the Nikkei 225 Futures in Osaka can be partially, but by no means wholly, blamed on the poor turnover/liquidity of some component shares in Tokyo and the subsequent staleness of the reported index, not necessarily on market inefciency.22 Therefore, the estimated ex ante violations, perhaps including the large ones shown in Table 1, may not necessarily represent real arbitrage opportunities.

5.4. Spot Market Turnover/Liquidity and Autocorrelation of Price Changes of the Nikkei 225 Index and the Nikkei 225 Futures The reported index quote, such as the one we use, is not a perfect measure of the true value of the cash index because the component shares of a stock index are not traded continuously. This means that the reported index can lag behind the true value of the index. To investigate the degree to which the reported Nikkei 225 Index represents the stale cash value of the index, we rst calculate the serial correlations of price-change series during the entire sample period. If we nd that futures price changes are not serially correlated but the index changes are, then this can be evidence of the non-synchronous trading problem and subsequent stale index quotation.23 Panel A of Table 3 indicates that the futures price series for ve-minute intervals display some evidence of statistically signicant serial correlation up to the third lag. However, the futures price series for 15-minute intervals display little evidence of signicant serial correlation beyond the rst lag: The rst-order autocorrelation (on the average, 0.052) is statistically signicant but economically trivial, given the large sample size.24 In contrast, the reported Nikkei 225 Index is signicantly autocorrelated, though diminishing as we lengthen the interval. The third and

186

Table 3. Autocorrelations of Changes in the Nikkei 225 Index and Its Futures Prices and Ex Post Boundary Violations by NSA Futures Prices.a
Panel A: Autocorrelation Coefcients for the Entire Sample Period (751 Trading Days)b Lag 5-Min Interval Data Nikkei Futures 1 2 3 4 0.046 0.021 0.018 0.002

10-Min Interval Data Nikkei Obs. 33260 31772 30284 28796 Futures 0.056 0.005 0.031 0.023

15-Min Interval Data Nikkei Obs. Futures 0.052 0.017 0.007 0.032

Y. PETER CHUNG, JUN-KOO KANG AND S. GHON RHEE

Nikkei Obs. 31649 30179 28709 27239 Index 0.323 0.171 0.112 0.070

Nikkei Obs. 14441 12971 11504 10038 Index 0.271 0.116 0.044 0.004

Nikkei Obs. 8697 7231 5768 4319 Index 0.244 0.058 0.010 0.017

Obs. 9102 7616 6130 4644

15140 13652 12165 10678

Panel B: Comparison of 649 Sample Trading Days for which All 225 NSA Component Stocks are Traded and 102 Sample Trading Days for which at Least One Index Component Stock is Not Traded at Allc Autocorrelations of 5-Min Price Change Series Nikkei Index 1st Order 2nd Order 3rd Order 1st Order Nikkei Futures 2nd Order 3rd Order Daily Average Violations All Contracts Sized Freq. (%)e L/T Contractsf Size Freq. (%)

649 Days (all 0.273 (28904) 0.126 (27614) 0.075 (26324) 0.049 (27903) 0.025 (26620) 0.019 (25337) 38.7 (88.9) 22.8 (34.6) 63.6 (112.6) 35.4 (39.9) stocks traded) 102 Days (not all 0.529 (4357) 0.355 (4159) 0.262 (3961) 0.035 (3746) 0.003 (3559) 0.013 (3372) 43.2 (89.2) 25.5 (37.2) 72.5 (113.5) 41.1 (42.4) stocks traded)

Index-Futures Arbitrage in Japan

Panel C: Comparison of 342 Sample Trading Days for which No Boundary Violation Occurs at All and 76 Sample Trading Days whose Daily Average Sizes of Violations are Among Top 10% of the Sample Days Autocorrelations of 5-Min Price Change Series NSA Index 1st Order 342 Days (no violation at all) 76 Days (top 10% violations)
a

Daily Average Violations All Contracts 3rd Order 0 Size Freq. (%) 0 0 L/T Contracts Size Freq. (%) 0

NSA Futures 3rd Order 1st Order 2nd Order

2nd Order

0.272 (15015) 0.148 (14336) 0.110 (13657) 0.039 (14374) 0.013 (13708) 0.01 (13042)

0.521 (3300)

0.356 (3150)

0.260 (3000)

0.086 (3050)

0.062 (2904)

0.036 (2758) 268.3 (127.5) 96.8 (10.6) 271.5 (126.6) 97.9 (4.98)

Futures price change is represented by the rate of change in futures price at t from t 1 ({(F (t , T ) F (t 1, T )}/F (t , T )); index price change is measured by the rate of return for the index at t from t 1 ({S (t ) S (t 1)}/S (t 1)). b Reported coefcients are the averages computed from 751 trading days in the sample. Coefcients with are signicant at 1%. c The number of observations is in parenthesis. d In terms of index points: a full index point is equivalent to 1,000 per contract. Standard deviation is in parenthesis. e The percentage out of daily number of observations. Standard deviation is in parenthesis. f L/T contracts represents contracts that have at least 40 days prior to expiration.

187

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Y. PETER CHUNG, JUN-KOO KANG AND S. GHON RHEE

higher lags do not display any signicant autocorrelation when the 15-minuteinterval data are used. However, the rst-order autocorrelation (on the average, 0.244) of the index price series is statistically and economically signicant even with the 15-minute-interval data. Given the signicant autocorrelation for our minute-by-minute spot index data, our empirical results should be interpreted accordingly. We then investigate whether there exists a signicant relation between the non-trading problem of the index stocks and the staleness of the spot index quotes. In Panel B of Table 3, we compare the autocorrelations of index and futures prices between days when all Nikkei 225 Index component stocks are traded (649 days) and days when at least one stock is not traded at all (102 days). Results indicate that the index quote change series is about two to three times more serially correlated during those 102 days than it is during the comparable 649 days, whereas the futures price change series does not show any signicant difference between the two groups. Clearly, non-synchronous trading of component stocks causes the index quote to be more autocorrelated, a phenomenon discussed in detail in Harris (1989a). Also, the size and frequency of ex post violations are larger on average when at least one stock is not traded at all, especially for longer-lived contracts that have at least 40 days prior to expiration.25 We have similar inferences from results in Panel C of Table 3. We rst stratify trading days into deciles according to their daily average size of ex post violations. We then calculate the autocorrelations of price-change series for the top 10% (76 days) of the sample days, and compare them with the autocorrelations for the 342 days for which no violation occurs. The spot index price-change series is again about two to three times more autocorrelated for those 76 days than it is for the 342 no-violation days. Further, those 76 days represent days for which most (96.8%) of the actual futures prices deviate a lot (268.3 index points) from the no-arbitrage boundary and persist throughout the day. In fact, 75 out of those 76 days experience mispricings only for longer-lived contracts.26 Note that autocorrelations of the futures price-change series show some difference between the two groups, though the difference is much less pronounced than that for autocorrelations of the spot index price-change series. In sum, we reafrm that the estimated ex ante violations, especially the large ones shown in Table 1, do not necessarily represent real arbitrage prots.

6. SUMMARY AND CONCLUSIONS

The purpose of this paper is to understand the unique Japanese market microstructure and demonstrate its impact on pricing index futures during the initial three years after the launching of the Nikkei 225 Futures in Osaka. We examine the

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189

minute-by-minute Nikkei 225 Index quotes of the TSE and the corresponding index futures transactions data of the OSE. We rst nd that the Nikkei 225 Futures contract prices on the OSE have tended to deviate frequently, on average 0.41%, from theoretical no-arbitrage prices with transaction costs. Also, observed ex post mispricings are clustered and persistent. Finally, the size and the frequency of ex post mispricings increase with longer-lived contracts. These ndings are broadly similar to what has been observed by other authors in studies of the U.S. markets. One question that remains unanswered is why there were occasional but big surges in estimated ex ante arbitrage prots as well as ex post mispricings even after the Japanese index futures market went through its infant stage. We nd that the question cannot be satisfactorily answered by those conventional market microstructure factors such as delays in execution, underestimated transaction costs, or difculties in short sales of index stocks. We, therefore, propose and test one potential explanation for this puzzle: the time-varying liquidity of some Nikkei 225 Index component shares on the TSE, especially for those closely-held shares. We provide evidence that the puzzling surges in the estimated mispricings of the Nikkei 225 Futures in Osaka can be partially, but by no means entirely, blamed on the poor turnover/liquidity of some component shares in Tokyo and the subsequent staleness of the reported index. Accordingly, the estimated ex ante violations, especially the large ones observed occasionally for long-lived contracts, do not necessarily represent real arbitrage prots. If the time-varying liquidity and occasional non-trading of component stocks of the Nikkei 225 Index are ignored, spurious conclusions about market efciency and the relation between the futures and cash markets can be obtained and arbitrage opportunities in Japan can be falsely identied. Nevertheless, one should be cautious in interpreting our results. Trading restrictions and execution risks in the Japanese stock and index futures markets may be more severe than what we can quantify in this paper. Future researchers, with the use of intraday transactions data for 225 component stocks, would also nd it useful to address further issues of thinly-traded Nikkei 225 Index component stocks, such as (1) can a smaller basket of liquid stocks do a good job of tracking the index? (2) can arbitrage prots be identied using a liquid subgroup of stocks? and (3) what would the arbitrage opportunities look like in Japan if the effect of the non- (or thin-) trading problem is eliminated using the method discussed in Harris (1989a, b)?

NOTES
1. Recent papers on the impact of market microstructure on securities pricing include Amihud and Mendelson (1987), Amihud, Mendelson and Murgia (1990), Fishman and

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Y. PETER CHUNG, JUN-KOO KANG AND S. GHON RHEE

Longstaff (1992), Grossman and Miller (1988), Grunbichler, Longstaff and Schwartz (1994), Hamao and Hasbrouck (1995), Lehmann and Modest (1994), Madhavan (1992), and Stoll and Whaley (1990). 2. Refer to Bacha and Fremault-Vila (1994) for further institutional details of the Nikkei 225 Index and its futures contracts during the study period which is similar to ours. 3. An implicit assumption here is that the bid-ask spread remains constant. Bae, Chan and Cheung (1999) report that the use of bid and ask prices (rather than transaction prices) improves the analysis of mispricing based on arbitrage between Hang Seng Index futures and options. 4. Short arbitrage means that the trader short sells component stocks of the index and buys futures contracts, while long arbitrage means the opposite. 5. For the estimation of transaction costs in recent periods, refer to Frino and West (2002). 6. Our estimates of transaction costs for brokers are slightly lower, while estimates for institutional investors are substantially higher, than those (1.03 and 2.59%) for the SGX Nikkei 225 Futures-based arbitrage estimated by Brenner, Subrahmanyam and Uno (1989). For the U.S. markets, Neal (1990) estimates that transaction costs were about 0.31% for the actual S&P 500-based index arbitrages in 1989 while Stoll and Whaley (1986) report that the costs were considerably higher (0.5% to 0.75%) in earlier years. A recent study by Fung, Mok and Lam (2000) reports that 0.055% for the U.S. S&P 500 Futures market and 0.125% for the Hang Seng Futures market in Hong Kong without presenting detailed cost breakdwon. These estimations include only commission and market-impact costs. 7. As reported in Bailey (1989), volatility of Japanese interest rates is so low that there would be no signicant difference between the cost-of-carry forward price such as Eq. (1) and the continuous-time futures price. Also, the dividend yield of the NSA is not smooth as the continuous-time model requires, but is rather lumpy due to the clustering of dividend payment dates by the underlying 225 companies in March and September. 8. The time stamp in the tapes represents the transaction time, not the reporting time. 9. We extract also from the Database the daily trading volume and the outstanding number of shares for each of the Nikkei 225 Index component stocks. These data are used to measure the Nikkei 225 Index spot market liquidity and turnover, which are discussed in Section 5. 10. The buy and hold to maturity strategy is only one possible strategy and may not be optimal for arbitrageurs. See Brennan and Schwartz (1990) for details. 11. Institutional trades account for about 30% of Nikkei 225 Futures trading volume. Our results, therefore, suggest that most of the institutional trades are non-arbitrage related (e.g. hedging). 12. As for the U.S. contracts, MacKinlay and Ramaswamy (1988) report an average deviation of 0.32% for the S&P 500 contracts during the rst four years of trading (1982 1986), whereas Chung (1991) reports an average deviation of 0.17% for the Major Market Index (MMI) contracts during the rst two years of trading (19841986). 13. Detailed results are not reported to save space but can be obtained from the authors upon request. MacKinlay and Ramaswamy (1988) report a similar persistence in the ex post mispricings for the S&P 500 contracts even when reasonable estimates of transaction costs are incorporated. 14. Detailed results are not reported but can be obtained from the authors. 15. For an earlier study that explains the reasons why ex ante tests are important and why they are what should be used for market efciency studies, see Dann, Mayers and Raab (1977).

Index-Futures Arbitrage in Japan

191

16. The TSEs CORES (Computer-assisted Order Routing and Execution System), implemented on January 23, 1982, is analogous to the NYSEs DOT (Designated Order Turnaround) system, but is much slower. On March 18, 1991, the TSE put FORES (Floor Order Routing and Execution System) into operation for 150 of the most active stocks. 17. The up-tick rule was introduced as of March 15, 2002. 18. See The Economist, 18th April 1992, pp. 8285. 19. The shares lent from Japanese institutions are often called back at the end of the scal year for reporting purposes. The end of the scal year for Japanese corporations is typically March. One can, therefore, suspect that this may explain the occasional, yet somewhat cyclical, ex post violations in Fig. 1. Mispricings are, in fact, most frequent and the largest on average in the months of March (58.7% and 186.6 index points) during our sample period. However, this seemingly seasonal effect is not consistent with the predominantly overpriced futures in March nor can it explain the surges in other months (e.g. September (36.2% and 80.2 index points)). 20. In contrast, Fung and Draper (1999) report that changes in short sale regulations affect mispricing of Hang Seng Index Futures contracts. 21. One can argue that substitutes may be found for the non-traded index component stocks in quasi-arbitrage. We poll Japanese brokers in order to elicit the practitioners point of view on this issue. The general consensus is that close substitutes are hard to nd because those non-traded index stocks are most likely closely-held shares whose idiosyncratic risks and liquidity are quite different from those of potential substitutes (e.g. frequently traded stocks with similar betas). See Harris (1989b) for a method of identifying potential substitutes for the S&P 500 stocks. 22. Index futures trading in Japan has been controversial, and there has always been tension between the regulators and active arbitrageurs. The Japanese Ministry of Finance and the TSE have, at least implicitly, subscribed to the view that index arbitrage causes excess volatility in the stock market. Accordingly, the regulations on the Nikkei 225 Futures trading have changed several times during our sample period. See Miller (1993) and Futures, June 1992, pp. 4850 for details. We investigate whether those changes in regulations, often in the direction of increasing impediments, are also responsible for those occasional surges in estimated mispricings of Nikkei 225 Futures. We look very hard for such evidence by stratifying our sample on the basis of different regulation regimes. We merely mention the results here in passing, as they are not very striking. In particular, we nd no evidence that increased (cash and total) margin requirements or tighter price limits on the OSE can explain this phenomenon. 23. For the effects of infrequent trading of component stocks on autocorrelation in the U.S. index, see Harris (1989a), MacKinlay and Ramaswamy (1988), and Miller, Muthuswamy and Whaley (1994). 24. We believe that observed positive autocorrelations are partially attributed to price limits imposed on the Nikkei 225 Futures trading. Refer to Berkman and Steenbeek (1998) and Martens and Steenbeek (2001). 25. Differences in size and frequency are not very big. Recall, however, that the size and frequency of ex post violations are positively related to the number of non-traded component shares of the index. One may also suspect that it is more likely that thin trading in all or some stocks in general may be the cause of higher positive serial correlations of the index. This point of view is addressed by stratifying the 751 sample trading days into deciles, based on the trading depth variables in Table 2 (TONUMBER, TOPERCENT, and NLOWTO). We

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Y. PETER CHUNG, JUN-KOO KANG AND S. GHON RHEE

do not, however, nd any signicant differences in serial correlations of the index among days of various trading depth. Thus, non-trading of one or more stocks on a given day is a much more serious constraint to arbitrageurs than thin-trading of all or some stocks. 26. A tracking portfolio containing a smaller basket of liquid Nikkei 225 Index stocks must allow for a greater margin of tracking errors and more costly portfolio adjustments prior to expiration of longer-lived contracts. Consequently, larger deviations may be required to induce arbitrageurs to take a position in longer-term contracts. This can be an important reason for larger estimated mispricings of longer-lived contracts, as some component stocks of the Nikkei 225 Index are occasionally not traded. At the same time, however, tracking is imperfect and index arbitrage is not risk-free.

ACKNOWLEDGMENTS
We are grateful for the comments and suggestions received on earlier drafts from Obiyathulla Bacha, Warren Bailey, Kalok Chan, Mark Grinblatt, Herb Johnson, Andrew Lo, Craig MacKinlay, David Mayers, Merton Miller, Myron Slovin, Richard Smith, Patrick Traichal, Anne F. Vila, and the participants in nance seminars at Arizona State, Boston University, City University of Hong Kong, Hitotsubashi, Korea Securities Research Institute, and Rhode Island. Special thanks are due to the Daiwa Institute of Research, Ltd., especially Toru Fukuda, for supplying the data, and Minoru Nakamura, Hisao Tanaka, and Takao Tsutsumi of the Osaka Securities Exchange and Benjamin Foo, Susie Liau, and Dennis Seet of the Singapore Exchange (formerly the Singapore International Monetary Exchange) for answering many questions.

REFERENCES
Amihud, Y., & Mendelson, H. (1987). Trading mechanisms and stock returns: An empirical investigation. Journal of Finance, 42, 533553. Amihud, Y., Mendelson, H., & Murgia, M. (1990). Stock market microstructure and return volatility: Evidence from Italy. Journal of Banking and Finance, 14, 423440. Bacha, O., & Fremault-Vila, A. (1994). Futures markets, regulation and volatility: The case of the Nikkei stock index futures markets. Pacic-Basin Finance Journal, 2, 201225. Bae, K., Chan, K., & Cheung, Y.-L. (1999). The protability of index futures arbitrage: Evidence from bid-ask quotes. Journal of Futures Markets, 7, 743763. Bailey, W. (1989). The market for Japanese stock index futures: Some preliminary evidence. Journal of Futures Markets, 9, 283295. Berkman, H., & Steenbeek, O. W. (1998). Daily price limits and trading in Nikkei futures. Journal of Futures Markets, 18, 265279. Brennan, M., & Schwartz, E. (1990). Arbitrage in stock index futures. Journal of Business, 63, S7S32. Brenner, M., Subrahmanyam, M., & Uno, J. (1989). The behavior of prices in the Nikkei spot and futures markets. Journal of Financial Economics, 23, 363384.

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Chung, Y. (1991). A transactions data test of stock index futures market efciency and index arbitrage protability. Journal of Finance, 46, 17911809. Dann, L., Mayers, D., & Raab, R., Jr. (1977). Trading rules, large blocks and the speed of price adjustment. Journal of Financial Economics, 4, 322. Fishman, M., & Longstaff, F. (1992). Dual trading in futures markets. Journal of Finance, 47, 643671. Frino, A., & West, A. (2002). The impact of transaction costs on price discovery: Evidence from cross-listed stock index futures contracts. Pacic-Basin Finance Journal, 10, 113. Fung, J. K. W., & Draper, J. (1999). Mispricing of index futures contracts and short sales constraints. Journal of Futures Markets, 19, 695715. Fung, A. K. W., Mok, D. M. Y., & Lam, K. (2000). Intraday price reversals for index futures in the U.S. and Hong Kong. Journal of Banking and Finance, 24, 11791201. Grossman, S., & Miller, M. (1988). Liquidity and market structure. Journal of Finance, 43, 617633. Grunbichler, A., Longstaff, F., & Schwartz, E. (1994). Electronic screen trading and the transmission of information: An empirical examination. Journal of Financial Intermediation, 3, 166187. Hamao, Y., & Hasbrouck, J. (1995). Securities trading in the absence of dealers: Trades and quotes on the Tokyo stock exchange. Review of Financial Studies, 8, 849878. Harris, L. (1989a). The October 1987 S&P 500 stock-futures basis. Journal of Finance, 44, 7799. Harris, L. (1989b). S&P 500 cash stock price volatility. Journal of Finance, 44, 11551175. Lehmann, B., & Modest, D. (1994). Trading and liquidity on the Tokyo Stock Exchange: A birds eye view. Journal of Finance, 49, 951984. MacKinlay, C., & Ramaswamy, K. (1988). Program trading and the behavior of stock index futures prices. Review of Financial Studies, 1, 137158. Madhavan, A. (1992). Trading mechanisms in securities markets. Journal of Finance, 47, 607641. Martens, M., & Steenbeek, O. W. (2001). Intraday trading halts in the Nikkei futures market. PacicBasin Finance Journal, 9, 535561. Miller, M. (1993). The economics and politics of index arbitrage in the U.S. and Japan. Pacic-Basin Finance Journal, 1, 311. Miller, M., Muthuswamy, J., & Whaley, R. (1994). Mean reversion of S&P 500 index basis changes: Arbitrage-induced or statistical illusion? Journal of Finance, 49, 479513. Neal, R. (1990). Program trading on the NYSE: A descriptive analysis and estimates of the intra-day impact on stock returns, Working Paper, University of Washington. Report of the Presidential Task Force on Market Mechanisms (1988). U.S. Government Printing Ofce, Washington, DC. Stoll, H., & Whaley, R. (1986). Expiration day effects of index options and futures, Monograph Series in Finance and Economics. New York University. Stoll, H., & Whaley, R. (1990). Stock market structure and volatility. Review of Financial Studies, 3, 3771.

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APPENDIX A
Estimation of Transaction Costs for Typical Index Arbitrage in Japan These estimates are in terms of percentages of the underlying index value, and for our sample period of September 9, 1988 to September 12, 1991. Some of the costs were changed afterward. Long arbitrage means that the trader buys component stocks of the index and sells futures contracts while short arbitrage means the opposite. Institutional Investors (%) (1) Stock brokerage commissions (round-trip) (2) Security transfer tax (3) Market-impact (two for stocks) (4) Futures brokerage commissions (one-way) (5) Market-impact (one for futures) (6) Cost of borrowing stocks for short sales (7) Futures margin in cash (% of contract value) Total Long arbitrage Short arbitrage 1.700 0.550/0.300 0.600 0.056 0.050 0.100 3/5/7/8 Brokers (%)

0.010 0.180/0.120 0.600 0.001 0.050 0.100 0/0/2/5

2.956/2.706 + IM 3.056/2.806 + IM

0.841/0.781 + IM 0.941/0.881 + IM

(a) Brokers pay only the round-trip usage fees (0.0048% to the TSE and 0.0041% to Saitori members). (b) The tax law changed on April 1, 1989. (c) There are two stock market-impact costs instead of one, as in the U.S. stock market, and they represent the effective bid-ask spreads for a given transaction size. Since the market-on-close or market-on-open order is not guaranteed an execution in the absence of a responsible market maker, it is realistic to assume that sizable transactions cannot be undertaken in the stock market

Index-Futures Arbitrage in Japan

195

(d) (e)

(f) (g)

without changing the previous market price when arbitrageurs wind up their spot position. Note that there are no costs in closing stock positions on the NYSE on expiration days of futures since a market-on-close order eliminates the market impact cost. Brokers pay a usage fee for opening the position through the nal settlement of contracts. In the U.S., brokers can lend stocks in street name, but in Japan institutions normally charge a fee of 0.1% of the value of shares lent for lending the stocks. Note that this estimate is very conservative, though somewhat typical, and may underestimate the true costs associated with borrowing stocks for short sale since those institutions occasionally demand up to 11.5%. It is mostly one tick. This is a unique feature of Nikkei 225 Futures contracts in Osaka. Margin cannot be withdrawn until the position is closed, and a xed percentage of the contract value should be put up in non-interest-bearing cash, forcing a positive net investment for index arbitrage. Numbers indicate the percentage of the contract value that must be put in cash on or after 880903/900824/910103/910627; IM = interest lost on cash margin. This is different from the other global contracts, where the initial margin can be put up in interest-bearing securities and the variation margin can be withdrawn depending on the direction of the market in relation to the position of the trader.

APPENDIX B
Summary of NSA Index Stocks that Experience at Least One Non-trading Day During the Period of September 9, 1988 to September 12, 1991 (751 Trading Days)

Firm Name

Industry

Number of Non-trading Days 1 1 11 1 7

1 2 3 4 5

SUMITOMO COAL MINING NISSHIN FLOUR MILLING TAITO TAKARA SHUZO GODO SHUSEI

Mining Foods Foods Foods Foods

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Y. PETER CHUNG, JUN-KOO KANG AND S. GHON RHEE

APPENDIX B (Continued )
Firm Name Industry Number of Non-trading Days 4 3 18 1 2 12 20 4 1 1 4 2 2 1 1 1 1 1 1 1 2 4 1 3 3 1 1 5 3 1 1 1

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37

HONEN CORPORATION KIKKOMAN CORP. KATAKURA INDUSTRIES NISSHINBO INDUSTRIES JAPAN WOOL TEXTILE DAITO WOOLEN TEIKOKU SEN-I TOHO RAYON MITSUBISHI PAPER MILLS HOKUETSU PAPER MILLS RASA INDUSTRIES NIPPON CARBIDE ASAHI DENKA KOGYO K. K. NOF CORP. DAINIPPON PHARM. NIPPON OIL SHOWA SHELL SEKIYU K. K. MITSUBISHI OIL NIPPON CARBON NORITAKE SHINAGAWA REFRACTORIES NIPPON STAINLESS STEEL NIPPON METAL INDUSTRY TOHO ZINC SHIMURA KAKO TOKYO ROPE MFG. OKUMA CORPORATION NIPPON PISTON RING YUASA CORP. HINO MOTORS SUZUKI MOTOR TAKASHIMAYA

Foods Foods Textiles Textiles Textiles Textiles Textiles Textiles Pulp and paper Pulp and paper Chemical Chemical Chemical Chemical Chemical Petroleum Petroleum Petroleum Glass and ceramics Glass and ceramics Glass and ceramics Iron and steel Iron and steel Non-ferrous metal Non-ferrous metal Metal Product Machinery Transportation equipment Electric machinery Electric machinery Electric machinery Retail

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197

APPENDIX B (Continued )
Firm Name Industry Number of Non-trading Days 23 1 1 6 5 1 2 5 11 2 1

38 39 40 41 42 43 44 45 46 47 48

MATSUZAKAYA SAKURA BANK JAPAN SECS FINANCE NAVIX LINE LTD JAPAN AIRLINES CO. LTD. MITSUBISHI WAREHOUSE MITSUI-SOKO CO. LTD. SHOCHIKU TOHO TOEI CO. LTD. TOKYO DOME CORPORATION

Retail Bank Securities Shipping Air Transportation Warehousing and Wharng Warehousing and Wharng Services Services Services Services