Shanghai index futures not quite the success they seem
03 June 2010
On the face of it, April’s launch of stock index futures trading in Shanghai has been a roaring success.
Even though mainland regulators introduced the new derivative contracts with their customary caution, restricting access to a handful of brokers and a few thousand favoured customers, dealing still started with a bang. On the first day of trading, more than 58,000 contracts changed hands, worth an impressive 60 billion yuan (HK$68.46 billion).
Since then, the new China Financial Futures Exchange has gone from strength to strength as investors flocked to deal in the futures contracts on the country’s blue-chip CSI 300 stock index. Yesterday, more than 358,000 contracts were traded, worth an astounding 300 billion yuan.
Altogether since the new contract was launched, total turnover has reached a nominal 6.7 trillion yuan. To put that number into perspective, it is equivalent to 20 per cent of China’s gross domestic product for last year. Or, to put it another way, it is as if the entire economic output of Australia had changed hands on the Shanghai exchange in the seven short weeks since dealing started.
Clearly, trading in the new stock index futures is busy. But busy is not necessarily the same as successful.
A successful futures contract is one that allows investors to implement their asset allocation decisions effectively and to hedge against risks in their underlying portfolio accurately. To achieve that, a contract must be liquid, and its pricing must be efficient.
Well, as we have seen, the Shanghai index futures are certainly liquid. Unfortunately, however, their pricing is anything but efficient.
To appreciate what is wrong with the new contract, we first have to understand how stock index futures should be priced when a market is working well.
And that means we have to forget everything we have ever read in the financial media about how the price of a futures contract tells us where the market “expects” the underlying index to be at some point in the future.
You have probably read that a hundred times. But it’s rubbish. Futures prices tell us nothing of the kind.
In fact, when a market is operating properly, the price of a stock index future tells us remarkably little. An index futures contract is simply the commitment to buy a collection of stocks at a fixed point in the future. As a result, the value of that contract is simply the value of the underlying index, plus the interest income you would earn if you kept your money on deposit in the meantime, minus the dividend income you would forgo by not holding the underlying stocks.
This makes good sense if you think about it. After all, if the futures price were to climb above this “fair value”, you would be able to make a riskless profit by selling the futures contract and buying the underlying stocks to deliver on expiry.
Similarly, if the futures price were to dip below fair value, you could sell the underlying stocks short and use the income to buy futures on the cheap, pocketing the difference.
In an efficient market, any deviations that open up between the price of a futures contract and its fair value get arbitraged away in very short order indeed.
Here’s the problem with the Shanghai contract: for a futures market to work efficiently, there needs to be a seamless interchange between the derivatives and the underlying stocks, with dealers who are long in the futures market able to hedge their exposure by shorting the underlying stocks.
In the mainland market, this is difficult, if not actually impossible. Short selling has been introduced, but only in a trial programme limited to six brokers.
As a result, there are gaping inefficiencies in the pricing of the new index futures contact. The first chart below shows how the closing price for the front month futures contract has strayed from its estimated fair value each day since trading began in April.
The deviations from fair value are significant, as great as 2 per cent or more. And that’s just the closing prices. Brokers say the intraday discrepancies can be as high as 6 per cent. Contrast that with a more efficient market like London, shown in the second chart, where the deviations from estimated fair value are typically less than 0.5 per cent (a discrepancy accounted for here by my simplifying assumptions on dividend yields).
No doubt the pricing in China’s market will improve over time as arbitrage between futures and the underlying stocks becomes easier.
But in the meantime, the inefficiencies of the market are troubling. Far from offering an effective hedging tool, its pricing discrepancies mean the new index futures contract is simply a giant leveraged casino with limited links to the underlying market. It may have generated impressive volumes, but you can hardly call it a success.