Stock Futures of a Flawed Market Index

Abstract

I present evidence that transactions of the stock futures of a flawed market index cause mispricing in individual stocks. In particular, I analyze whether stocks overweighted on the index are mispriced, especially when market movements driven by futures trading are observed. To detect such movements, I use a qualitative indicator based on daily stock market news and a quantitative indicator based on the intraday lead-lag relationship between the spot and futures markets. I first find that overweighted stocks experience higher (lower) returns when an upward (downward) market movement driven by futures trading occurs. Second, they experience lower (higher) returns after such periods, i.e., their performance is reversed. These findings suggest that overweighted stocks experience significant trading pressure from the transactions of the index futures, resulting in mispricing of individual stocks. By contrast, such price behavior is not observed for non-constituent stocks. These results strongly support the view that the transactions of stock futures of a flawed index cause mispricing in individual stocks.