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The Costs of Arbitrage and Futures Market Trading Activity

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  • Michael Bowe

Abstract

Standardizing a futures contract's specifications to enhance its transfer-ability is problematic for any commodity whose cash market adopts relational contracting procedures. Standardization implies the contract's value cannot be completely determined by competitive arbitrage order flow, inhibiting the market's price discovery function, and leaving the futures price susceptible to manipulation. These effects may result in the market's failure. The model, based on the theory of storage, predicts that contracts with a higher spread-open position price volatility are more likely to contain a range of arbitrage indeterminacy, hence to experience difficulties in sustaining trading. The prediction is supported in an empirical examination of 104 US futures markets. The range of indeterminacy also increases the informational requirements of spread traders, reducing the effectiveness of spread arbitrage in maintaining the equilibrium intertemporal futures pricing relationship. Detailed evidence from 15 US contract markets demonstrates spread arbitrage is less effective in contract markets which subsequently fail.

Suggested Citation

  • Michael Bowe, 1994. "The Costs of Arbitrage and Futures Market Trading Activity," International Journal of the Economics of Business, Taylor & Francis Journals, vol. 1(2), pages 247-270.
    • Handle: RePEc:taf:ijecbs:v:1:y:1994:i:2:p:247-270
    DOI: 10.1080/758516798
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    More about this item

    Keywords

    Futures contracts; Futures price spreads; Storage; Arbitrage; JEL classfications: D23; G10; G13;
    All these keywords.

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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