STANDARD & POOR’S DEPOSITARY RECEIPTS AND THE MARKET QUALITY OF S&P 500 INDEX FUTURES

This study examines the market quality of S&P 500 index futures in 150-day periods before and after the introduction of Standard & Poor’s Depositary Receipts, SPDRs, on January 29, 1993. In a preliminary test of structure change, results fail to reject the null hypothesis that the empirical distributions of daily futures price changes in the two periods are the same. Market quality is measured by the deviation of observed prices from the unobserved implicit efficient price. A lower pricing error variance from a vector autoregression (VAR) model implies better market quality. Using tick-by-tick intra-day S&P 500 index futures price data, we find a lower pricing error standard deviation of 0.26 percent in the post-SPDR period than in the pre-SPDR period (0.32 percent). This finding indicates an improvement in the quality of the S&P 500 index futures market following the introduction of SPDRs attributable to improvement in the microstructure of the market. As SPDRs facilitate index arbitrage, adjustment of prices in the index futures market takes less time, leading to lower pricing error variance, or improved market quality. In the post-SPDR period, we apply a vector error correction model (VECM) to two pairs of intra-day (futures, index) prices and (futures, SPDR) prices. The VECM approach shows better quality in the S&P 500 index futures market from its arbitrage relationship with SPDRs. We conclude that it is this arbitrage relationship between index futures and SPDRs that improves S&P 500 index futures market quality after the introduction of SPDRs.