Essays on futures markets.

Abstract

Essays examine the issue of market efficiency in futures markets. Chapter 1, "Capacity of the Equity Index Futures Arbitrage Industry," is a theoretical modeling exercise that looks into the equilibrium number of firms in an equity index futures arbitrage industry. Assuming perfect competition, the equilibrium number of firms is attained when economic profit is zero for each firm. Under this condition, arbitrage transaction costs are important determinants of the equilibrium. It is shown that the equilibrium number of firms in this industry is inversely related with the variable cost components. Chapter 2, "The Learning Curve Effect in Financial Futures Markets," investigates equity index and fixed income futures markets for evidence of the decreasing average cost of arbitrage in these markets as arbitrageurs gain more experience. Regression analyses, using deviation of observed prices from the cost of carry equilibrium as a proxy measure for the arbitrage average cost and cumulative volume for the amount of experience gained by the participants, produce evidence supporting the hypothesis of the learning curve effect. Choice of the proxy variable is based on the observation that the mispricing as defined should track the average cost of the most efficient arbitrageur. Other variables such as technology that may have an impact on market efficiency is controlled for by "time" as their proxy variable. However, due to colinearity between cumulative volume and time, the evidence needs to be interpreted with caution. The last chapter, "Market Efficiency Dynamics: How the Efficiency in Newly Emerged Futures Markets Evolves," explores the characteristics of evolving market efficiency. Futures markets are chosen because there are several relatively new futures contracts on various types of assets. Diversity of contracts that are active in futures markets offers an excellent chance to cross check the results. Three test methods that are distinguished by measurement of the extent of market efficiency are implemented: the autocorrelation test, the variance ratio test, and the mispricing test. This helps to compensate for any weakness in each test method. Particular attention is paid to the role of trading volume as an important factor for continuing improvement in market efficiency. Other variables that may affect the market efficiency dynamics such as time remaining till contract expiration and market volatilities are controlled for in regression analyses. Evidence is found to support the fact that both cumulative and contemporaneous volumes play important roles in continually improving market efficiency for most futures markets covered. This is interpreted as suggesting the presence of the learning by doing effect in financial markets.