Informed Trading, Short Sales Constraints, and Futures' Pricing

Bank of Finland Discussion Papers 4/2000

32 Pages Posted: 28 Mar 2000

See all articles by Yrjo Koskinen

Yrjo Koskinen

Haskayne School of Business, University of Calgary

Pekka Hietala

INSEAD - Finance

Esa Jokivuolle

Bank of Finland, Research Unit

Multiple version iconThere are 2 versions of this paper

Date Written: May 18, 2000

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' markets, short sales constraints, asymmetric information

JEL Classification: G13, G14

Suggested Citation

Koskinen, Yrjo J and Hietala, Pekka and Jokivuolle, Esa, Informed Trading, Short Sales Constraints, and Futures' Pricing (May 18, 2000). Bank of Finland Discussion Papers 4/2000. Available at SSRN: https://ssrn.com/abstract=217268 or http://dx.doi.org/10.2139/ssrn.217268

Yrjo J Koskinen (Contact Author)

Haskayne School of Business, University of Calgary ( email )

SH 154, 2500 University Drive NW
Calgary, Alberta T2N 1N4
Canada
+1-403-220-5540 (Phone)

HOME PAGE: http://contacts.ucalgary.ca/info/ha/profiles/1-7257931

Pekka Hietala

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France
+33 1 6072 4178 (Phone)
+33 1 6072 4045 (Fax)

HOME PAGE: http://www.insead.fr/facultyresearch/finance/hietala/

Esa Jokivuolle

Bank of Finland, Research Unit ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland
+358 10 831 2309 (Phone)

HOME PAGE: http://www.bof.fi/en/suomen_pankki/organisaatio/asiantuntijoita/jokivuolle_esa/

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