THE PROFITABILITY OF INDEX FUTURES ARBITRAGE - EVIDENCE FROM BID-ASK QUOTES

Previous studies investigated the profitability of stock index futures based on transaction price data, and could overstate the frequency of arbitrage opportunities and size of arbitrage profits. This article o btains a data base for the Hong Kong index futures and index options m arket that contains both real-time transaction prices and bid-ask quot es; the article further examines the bias of identifying arbitrage opp ortunities based on transaction prices. The article finds the percenta ge of observations violating no-arbitrage bounds is significantly redu ced when bid-ask quotes are employed instead of transaction prices, Th is suggests studies that implement arbitrage strategies based on trans action prices employ prices from the wrong side of the spread. This ar ticle finds a relationship between the frequency of violations (evalua ted from transaction prices) and the size of bid-ask spreads in the fu tures and options markets. This phenomenon indicates that a larger mis pricing, which may arise when the bid-ask spread is wider, does not ne cessarily imply profitable arbitrage opportunity. (C) 1998 John Wiley & Sons, Inc.