The Saga of the First Stock Index Futures Contract

Book excerpt: Futures contracts on stock indices can be subject to imperfect arbitrage-based pricing when the spot quot;goodquot; is not an easily held portfolio. The Kansas City Value Line (KCVL) stock index futures market provides an interesting case study because the spot index was complex and it underwent a change in definition from an equally-weighted geometric index to an equally-weighted arithmetic index for the futures to remain viable. The dynamics of geometric and arithmetic indices differ in their complexity and imply that KCVL(Geometric) futures should be priced using the relatively complex Eytan-Harpaz (1986) model, while KCVL(Arithmetic) futures can be priced using the standard Cost-of-Carry model. Empirical analysis of outright and calendar spread prices reveals that KCVL(Geometric) futures went through three distinct phases of mispricing reflecting considerable confusion in pricing. An intriguing result is that during the second phase lasting four years, traders in the KCVL(Geometric) market appear to have been unaware of the magnitude and importance of the properties of the geometric index. Specifically, the market treated these geometric futures contracts like conventional futures contracts based on physical commodities, and induced quot;efficiencyquot; from the incorrect perspective of the Cost-of-Carry model. A dramatic correction follows in the third quarter of 1986 around the publication of the Eytan-Harpaz model when the market turns efficient from the correct perspective of this new model. Jointly, the results suggest that it is possible for a modern market to succumb to a self-fulfilling prophecy induced by the force of behavior and belief, and be quot;efficientquot; but wrong. Further, it appears that the market did not learn the correct model from trading. The correction occurred, instead, around the time of the publication of the correct model, which could be viewed as a re-interpretation of existing information in a manner that altered the state of knowledge in the market. The evidence suggests also that we may need to draw more on the distinctions among the words information, belief, and knowledge, in our definition of efficiency; information being available need not imply that it will be processed appropriately through trading.