Mispricing of index futures contracts and short sales constraints

Abstract

This article examines if changes in short sales constraints affect the extent to which index futures contracts are mispriced. In particular, the study analyzes the mispricing of the Hong Kong Hang Seng Index futures contracts. Tests are conducted over three distinct regulatory regimes relating to the short selling of stocks in Hong Kong. This permits a study of how changes in short selling regulations affect the mispricing of futures contracts. The study indicates that relaxing the constraints on short selling reduces the extent of futures mispricing. Multiple regression analysis is used to test the relationship between the magnitude of mispricing and various economic factors including cash market volatility, time-to-maturity of the contract, trading cost, and dividend payout rates. The study also finds that lifting of the short selling restrictions speeds up market adjustment, especially when a long-hedge (long futures, short stock) signal is detected. © 1999 John Wiley & Sons, Inc. Jrl Fut Mark 19: 695–715, 1999