A re-examination of the relationship between FTSE100 index and futures prices

This thesis examines the validity of the cost of carry model for pricing FTSE100 futures contracts and the relationship between FTSE100 spot and futures markets during twosub-periods characterised by different market trading systems employed by the LSEand LIFFE. The empirical work is carried out using three approaches to econometricmodeling: a basic VECM for spot and futures prices, a VECM extended with a DCCTGARCHframework to account for the conditional variance-covariance structure forspot and futures prices and a threshold VECM to capture regime-dependent spot-futuresprice dynamics.Overall, both the basic VECM and the DCC-TGARCH analysis suggest that there aredeviations from the cost of carry relationship in the first sub-sample when transactionscosts in both markets are relatively high but that the cost of carry relationship tends tobe valid in the second sub-sample when transactions costs are lower. This is furtherconfirmed by the evidence of higher conditional correlations between the two marketsin the second sub-sample as compared with the first, using the DCC-TGARCH analysis.This implies that the no-arbitrage cost of carry relationship between spot and futuresmarkets is more effectively maintained by index arbitrageurs in the second period whenmarket conditions are closer to perfect market assumptions, and hence the cost of carrymodel could be more reasonably used as a benchmark for pricing stock index futures.The threshold VECM analysis depicts regime-dependent price dynamics betweenFTSE100 spot and futures markets and leads to some interesting and important findings:arbitrage may not be practicable under some market conditions, either because it isdifficult to find counterparties for the arbitrage transactions, or because there issignificant risk associated with arbitrage; as a result, the cost of carry model may notalways be suitable for pricing stock index futures. Furthermore, the threshold valuesyielded from estimating the threshold VECM reflect the average transaction costs formost arbitrageurs that are more reliable and fair than subjective estimations.