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Stock Futures of a Flawed Market Index

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Abstract

I present evidence that transactions of the stock futures of a flawed market index cause mispricing in individual stocks. In particular, I analyze whether stocks overweighted on the index are mispriced, especially when market movements driven by futures trading are observed. To detect such movements, I use a qualitative indicator based on daily stock market news and a quantitative indicator based on the intraday lead-lag relationship between the spot and futures markets. I first find that overweighted stocks experience higher (lower) returns when an upward (downward) market movement driven by futures trading occurs. Second, they experience lower (higher) returns after such periods, i.e., their performance is reversed. These findings suggest that overweighted stocks experience significant trading pressure from the transactions of the index futures, resulting in mispricing of individual stocks. By contrast, such price behavior is not observed for non-constituent stocks. These results strongly support the view that the transactions of stock futures of a flawed index cause mispricing in individual stocks.

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Notes

  1. Lately, some stock market indices such as the S&P 500 and TOPIX have changed to float-adjusted cap weighting, which provides a more accurate reflection of market movements.

  2. Firms with higher share prices do not necessarily make greater contributions to the economy. Therefore, the price-weighting system is also greatly disadvantageous in terms of measuring market performance.

  3. These studies show that index futures returns tend to lead stock market returns.

  4. The Dow Jones Industrial Average is the well-known price-weighted index of the U.S. stock market. However, Dow Jones Industrial Average futures are much less traded than S&P 500 index futures by investors. Thus, Nikkei 225 futures can be considered to be a more representative example of the influential stock futures of a price-weighted index futures than Dow Jones futures.

  5. In addition, Akeda (1990) mentions the possibility that the returns of high-priced illiquid constituent stocks are influenced by Nikkei 225 portfolio transactions. In line with his prediction, Adachi (1991) shows that in the early 1990s (when the Japanese asset price bubble burst), prices of illiquid overweighted stocks excessively co-moved with (were excessively sensitive to) the Nikkei 225 index values.

  6. The TOPIX weight is based on free-float-adjusted capitalization to provide a more accurate reflection of the market movements. Even if I utilize a simple cap-weighted index as a market index, the implications of my results are unaffected.

  7. Approximately, the number of trading days over 1 month.

  8. The original definition of illiquidity is the absolute value of a stock’s return divided by its dollar trading value (Amihud 2002). However, to reduce the currency effect on evaluating illiquidity, the denominator is set to the yen trading value.

  9. Since individual stock daily returns tend to have autocorrelation, I also evaluate the effect of overweighting after controlling for the one-day and two-day lagged daily returns in addition to the size, liquidity, and bid-ask spread. The results (available upon request) suggest that the implications of my results are unaffected by the autocorrelation issue.

  10. Since the change in overweighting over one day is quite limited, the effect of overweighing on day t-1 on stock returns \( R_{i,t + 1} \) (\( \upbeta_{{OW_{{1,{\text{t}}}} }} \)) is almost equal to the effect of overweighing on day t on stock returns \( R_{i,t + 1} \) (\( \upbeta_{{OW_{{0,{\text{t}} + 1}} }} \)).

  11. The word itself does not include the meaning of price movement. However, the word is usually used to qualify the price movement.

  12. Those include the case when a volatile market movement attributed to futures trading is mentioned in the article.

  13. I also use the indicator where those days with small market returns are excluded; however, implications of the results are unaffected. The detail of the analysis is described in Sect. 5.2.

  14. Even if I use the two indicators jointly to identify the days, the implications of my results are unaffected.

  15. Since \( \beta_{{OW_{s,t} }} \) is the effect on \( R_{i,t + s} \), the recent four-day market returns for \( \beta_{{OW_{s,t} }} \) are \( MR_{t + s - k} \) (k = 0, 1, 2, 3).

  16. To reduce the influence of outliers, the descriptive statistics for the effects of overweighting are based on winsorized values (at their first and 99th percentiles).

  17. Additionally, we regress the effect of overweighting on the two (quantitative and qualitative) indicators, jointly. The result also reveals that the one-day-ahead effect of overweighting has a significantly negative association with the quantitative indicator, and the two-day-ahead effect is negatively associated with the qualitative indicator.

  18. I also analyze other cutoff levels. The results (available upon request) still support my hypothesis.

  19. \( FI_{{2,{\text{t}}}} \) multiplied by absolute value of the stock return (\( \left| {{\text{MR}}_{\text{t}} } \right| \)) seems to be suitable factor to analyze the effect of significant movement driven by futures trading. However, the factor is highly correlated with one of the control variables, i.e., \( {\text{MR}}_{\text{t}} \) (the correlation coefficient is more than 0.7). Therefore, a reliable estimation of the association between the factor and \( \beta_{OW} \) is not available, due to multicollinearity.

  20. OWN has a value of zero for the Nikkei 225 constituents.

  21. If liquidity (trading volume) of spot market is decreased, investors more prefer to trade stock futures than the index constituents in the spot market. Thus, a decrease in spot market liquidity could increase market movements driven by futures transactions.

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  1. Tokio Marine Asset Management Co. Ltd, 1-3-1, Marunouchi, Chiyoda-ku, Tokyo, Japan

    Kotaro Miwa

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  1. Kotaro Miwa
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Miwa, K. Stock Futures of a Flawed Market Index. Asia-Pac Financ Markets 26, 1–21 (2019). https://doi.org/10.1007/s10690-018-9253-6

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