Informed Trading, Short Sales Constraints, and Futures' Pricing

The purpose of this paper is to provide an explanation for relative pricing of futures contracts with respect to underlying stocks based on short sales constraints and informational lags between the two markets. In this model stocks and futures are perfect substitutes, except 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 gets a negative signal about the common future value of stocks and futures, she is only able to sell futures. In addition uninformed traders also face 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 compared to futures, provided that market makers in stocks and futures only observe with a lag the order flow in the other market. 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 time that we have data (May 27, 1988 - May 31, 1994). We find strong empirical support for our implications.