Index Arbitrage - An Introduction

Have you often wondered why the Australian share market sometimes fluctuates wildly without any overt major market-moving news? The influence of the derivatives market, in particular the futures market, should not be underestimated.

At a glance the futures market prices are derived from the underlying physical market, but the driving influences are often the other way around, hence the market movements. The discussion that follows will centre around arbitrage institutions and how they take advantage of the share market through Index arbitrage between the physical market (shares) and the Futures market.

Basics First:

The SFE SPI 200 Futures contract is the benchmark equity index futures contract in Australia and is based on the S&P/ASX 200 Index. It expires on a quarterly basis and has a contract value of equivalent to the Index Level x $25. Each point movement per contract is also worth $25. With the Index at 4357 each SPI Futures contract is worth $108,925.

Arbitrageurs

Arbitrageurs are institutions that take advantage of price discrepancies between the Futures market and the physical by buying in the market which is relatively cheap and selling in the market which is relatively expensive.

An institution can buy a basket of shares on the sharemarket, which closely resembles a Futures contract, (i.e.) a diversified portfolio with market weightings up to $108,925 in value.

e.g. BHP = 12% of the ASX 200, so they would buy 12% x $108,925 worth of BHP shares and 11% of Telstra, etc, to replicate one futures contract. Of course in reality they will trade be in lots of 10 or 20 or even 100 contracts at a time.

Example

Assumption: It is temporarily cheaper to buy in the futures market than to buy in the physical market

In this example, it would be advantageous for the Arbitrage institutions to Sell the physical market  - (i.e.) sell stock replicating an underlying portfolio of shares equivalent to the ASX 200 - and Buy the Futures Market because at expiry the two markets converge. Their prices are then effectively the same because at expiry they represent two identical markets.

By replicating the ASX 200 index in selling the physical shares, they can simultaneously purchase Futures contracts in equivalent market value to the amount sold. In doing so, they effectively lock in an immediate riskless profit. See below.

At Expiry

At expiry, the two markets converge and SPI Futures are cash settled. The share position can then be reversed by buying back those shares initially sold.

Effectively, the gain to the arbitrage institutions would be:
Selling @ 4381.80 Buying @ 4400 = Loss on Physical - 18.2
Buying @ 4357.00, Selling @ 4400 = Gain on Futures + 43.0

Net gain 24.8 points per contract traded, or 24.8 x $25 = $620 and if they traded 100 contacts in value, this would equate to a $62,000 profit.