Applied Economics Letters, 2011, 18, 257261

The behaviour of individual traders and the persistence of arbitrage trading

Sang Buhm Hahna and Seungyeon Wonb,*
Department of Economics, Kyonggi University, San 94-6, Iui-dong, Yeongtong-gu, Suwon-si, Gyeonggi-do 443-760, Korea b Department of Business Administration, Myongji University, 50-3, Namgajwadong, Seodaemungu, Seoul, 120-728, Korea
a

This article analyses the influence of individual traders on the persistence of arbitrage opportunities, using futures market data from the Korea Composite Stock Price Index 200. The empirical results show that individual traders traded towards increasing arbitrage opportunities unlike other types of traders. This study helps explain the reason why arbitrage opportunities persist even when arbitrage trading is executed in the real world. According to our empirical results, arbitrage opportunities can persist if the behaviour of individual traders regarding arbitrage opportunities overwhelms other traders who are against arbitrage opportunities. This is not fully explained by previous studies that attributed the persistence of arbitrage opportunities to the limit to arbitrage. In this context, this study suggests that two separate arguments need to be combined for explaining arbitrage trading in the real world, namely studies of arbitrage trading and the behavioural approach.

I. Introduction Despite the market efficiency hypothesis, opportunities for arbitrage trading frequently arise in the stock index futures market. Some studies have supported the market efficiency hypothesis, showing the mean reversion in spot-future basis changes (Figlewski, 1984; MacKinlay and Ramaswamy, 1988; Miller et al., 1994; Neal, 1996). Conversely, many studies have reported the persistence of arbitrage trading. They proposed that mispricing might not be corrected in the market because of the limit to arbitrage and, as a result, persist for some time. Factors that limit arbitrage trading are thought to include capital constraints (Shleifer and Vishny, 1997), early redemption (Brennan and Schwartz, 1990) and collateral constraint (Liu and Longstaff, 2004).
*Corresponding author. E-mail: sywonb@yahoo.co.kr

In the real world, we sometimes observe that mispricing may persist and diverge from the current level, even if arbitrage trading is executed in the stock index futures market. Why does this happen even if the limit to arbitrage is not observed? Those studies that attributed the persistence of arbitrage opportunities to the limit to arbitrage did not suggest a reason that would explain the phenomenon. Regarding this phenomenon, this article takes a behavioural approach and proposes that noise traders can drive the price away from the equilibrium (De Long et al., 1990a, b). In the behavioural approach, the noise trader or the uninformed trader is acting as a positive feedback trader. Without considering the intrinsic values, this trader positively responds to the previous returns by buying securities that increased previously and selling those that decreased previously. If this trader does the same thing in the spot and futures index market, he/

Applied Economics Letters ISSN 13504851 print/ISSN 14664291 online # 2011 Taylor & Francis http://www.informaworld.com DOI: 10.1080/13504850903559526

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she will choose to buy the higher priced index between the two. Therefore, the noise trader can trade towards increasing arbitrage opportunities by buying overpriced futures or selling underpriced futures in the futures market. Surprisingly, the role of the noise trader has generally been neglected in academic arguments on arbitrage trading. In addition, the behavioural approach has rarely been considered in the dynamic process of arbitrage trading. This article tries to fill the gap between studies on arbitrage trading and the behavioural approach. With an empirical test using the Korea Composite Stock Price Index (KOSPI) 200 spot and futures markets, this article shows that individual traders work positively to increase mispricing between spot and futures prices, as do noise traders. This article also suggests that arbitrage opportunities persist longer as the trading of individual traders overwhelms that of other traders. The results may explain why arbitrage opportunities persist and sometimes expand despite existing arbitrage trading. The article is organized as follows. Sections II and III explain the empirical models and data, respectively. Section IV describes the empirical results. Section V presents the conclusion.

S. B. Hahn and S. Won

where MSt,T, margin rate of arbitrage trading; Bt,T (=Ft,T Tt,T), basis; St, spot price at time t; Ft,T, futures price with maturity T at time t; Tt,T, theoretical price of future with maturity T at time t; r, cash rate; d, dividends; T, maturity date of futures. As the transaction costs of arbitrage trading are positive in the real world, they should be deducted from the returns on arbitrage trading. For an empirical test, we included the trading fee, market impact cost, trading tax and bid-ask spread as the transaction costs of arbitrage trading. Only in backwardation cases, considering the cost that the arbitrageur should pay for borrowing securities in reverse cash-and-carry arbitrage, is the spread (at), i.e., the borrowing rate minus the cash rate, included as an additional charge. After calculating each cost using the ratio relative to the spot price, we get the total cost for arbitrage trading (TCt). We also define the returns of arbitrage trading (Mt,T, hereafter the return rate) as the absolute value of the margin rate (|MSt,T|) minus the total cost (TCt) (refer to Equation 2). As the return rates are the net returns on arbitraging trading, arbitrageurs will execute arbitrage trading when the return rates are positive. Mt;T   rdTt     MSt;T  TCt Ft;T St e TCt St 2

II. Model Calculation of returns on arbitrage trading Arbitrage trading in stock index futures is defined as trading simultaneously in the spot and futures markets to gain risk-free returns by utilizing the price gap between the spot and futures indices. If a basis (Bt,T) is defined as the futures price (Ft,T) minus the theoretical futures price (Tt,T), arbitrage trading is theoretically feasible, at least when the basis (Bt,T) is not 0. Under the assumption of no transaction cost, the margin rate of arbitrage (hereafter the margin rate), MSt,T, which is defined as the basis (Bt,T) divided by the spot price (St) would be the returns on arbitrage trading in Equation 1. Arbitrageurs execute a cashand-carry arbitrage strategy by buying the spot index and selling futures when there is a positive margin rate (hereafter the contango case), whereas they use a reverse cash-and-carry arbitrage strategy by selling the spot index and buying futures when there is a negative margin rate (hereafter the backwardation case). MSt;T Bt;T Ft;T Tt;T Ft;T St erdTt St St St 1

where Mt,T is the return rate of arbitrage trading. The behaviour of traders: response to the return rate of arbitrage When the return rates are positive, rational traders, including arbitrageurs, will execute trading towards decreasing the gap between spot prices and futures prices by selling overpriced securities and buying underpriced securities. Therefore, they will work to decrease arbitrage opportunities. Conversely, some traders may buy overpriced securities rather than underpriced ones. Some studies have found that positive feedback traders respond positively to the previous returns because they perceive the increases of previous returns as an indicator of increased returns in futures. Similar to positive feedback traders, some traders may buy the more expensive of two indices, with the expectation that the price of the expensive index will increase more than that of the cheap one. In this case, the traders will widen the gap between spot prices and futures prices and, as a result, cause arbitrage opportunities to persist. To analyse the influence of each type of trader on arbitrage opportunities, this article starts from

Individual traders and persistence of arbitrage trading

Table 1. Statistics for arbitrage trading Margin rate Number of observation Rate (%) Total cases 15 685 Average -0.3700 Cases for MSt . 0 5480 Maximum 4.6267 Cases for MSt , 0 10 205 Minimum -4.4784 Return rate Cases for Mt . 0 5439 Average 0.0100 Contango cases 795 Maximum 3.9967

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Backwardation cases 4644 Minimum -0.8763

Equation 3. Using the autocorrelation analysis method of Campbell et al. (1993), we consider the behaviour of each trader as the determinant factors for the autocorrelation of the return rate (Mt,T). The proxy variable used to explain the behaviours of traders is the trading intensity (|Qt|) in the futures market, which is the absolute value of the net purchase amount (buy amount sell amount) of each trader divided by the total open interest. If the coefficients of the trading intensities by a trader group are positive, it shows that those traders are positively influencing the persistence of arbitrage opportunities.
  Tt Mt a b0 b jQt j Mt1 jSt j et t 90

III. Data This study used the intraday data of the KOSPI 200 futures market from 10 March 2000 to 8 December 2005, obtained from the Korean Exchange. The futures data include not only the futures price but also the trading volume of each trader on a real-time basis. These data divide traders into individual, bank, stock, insurance, trust, foreign and others, and these categories are regrouped into three categories: individual, institutional and foreign traders. We can pick out the programme traders who seek gain by arbitrage trading from among the institutional traders. The Korean Exchange provides spot market data containing program trading data, which consist of arbitrage and non-arbitrage trading data. Of these, only the arbitrage trading data are regarded as a proxy for trading by arbitrageurs. After calculating their trading data, we redefined the trading volume of institutional investors as the trading volume obtained by deducting the trading of programme traders from that of the original institutional traders. As a result, traders are categorized into four

types: individual trader (individual), foreign trader (foreigner), institutional trader (excluding programme trader, hereafter institution) and programme trader (programmer). The intraday trading volume is summed every 30 minutes starting at 9 am, and the price variable is recorded at the end of each 30 minutes. In the case of intraday data, the data for 9 am (opening time) and 3 pm (closing time) are excluded. The sell and purchase amounts by each trader are summed every 30 minutes and then the net purchase amount (purchase amount sell amount) or net purchase ratios (net purchase amount divided by the total open interest) by the trader are calculated. The margin rates, transaction cost and return rates averaged to -0.370, 0.026 and 0.01%, respectively (refer to Table 1). Of 15 685 observations, 5480 had positive margin rates, whereas 10 205 had negative margin rates. The return rates were positive for 5439 out of 15 685 observations, or 34% of the total. These 5439 cases included 4644 backwardation cases and only 795 contango cases. There may have been fewer contango cases because of the limit of short positions in the spot market.

IV. Empirical Analysis Including the trading intensity of each trader separately in Equation 3, we estimated the coefficients of trading intensities. The result shows the contrasting influence of individuals and other traders (refer to Table 2). The trading intensities of other traders negatively influenced the autocorrelation of the return rates at a 1% significance level. The results show that institutions, foreigners and programmers executed trading towards decreasing arbitrage opportunities. In particular, the response of programmers to arbitrage opportunities was greater than that of institutions and foreigners, which implies that the programmers were arbitrageurs. Conversely, the trading intensity of individuals had a positive effect on the

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Table 2. Traders trading intensity and the persistence of arbitrage opportunities Dependent variables: Mt Equation 1 ai bi0 bi1 bi1 bi1 bi1 i (individual) (institution) (foreigner) (programmer) 0.0503*** (9.37) 0.0340*** (11.08) -0.613*** (-6.71) -0.7722*** (-9.64) -3.463*** (-20.05) 0.0478*** (9.01) 0.0349*** (11.53) Equation 2 Equation 3 -0.0367*** (-11.36) 0.945*** (208.73) Equation 4 -0.037*** (-11.71) 0.9579*** (250.02) Equation 5 -0.037*** (-11.62) 0.968*** (167.22) 0.545*** (6.59) -0.536*** (-5.49) -0.528*** (-6.11) -3.094*** (-17.18) 0.046*** (8.77) 0.036*** (11.86)

S. B. Hahn and S. Won

Equation 6 (Mt . 0) -0.232*** (-61.31) 1.158*** (137.63) 0.828*** (6.87) -0.858*** (-6.05) -0.737*** (-5.86) -3.514*** (-12.76) 0.084*** (12.93) 0.026*** (7.04)

Equation 7 (Mt , 0) 0.057*** (7.80) 1.617*** (59.05) -0.265 (-0.81) -1.453*** (-3.81) -0.923** (-2.59) -2.42*** (-3.60) 0.360*** (34.39) 0.075*** (12.13)

-0.036*** -0.036*** (-11.183) (-11.182) -0.907*** 0.9374*** (188.72) (198.62) 0.1452* (1.95)

0.0496*** 0.0498*** (9.25) (9.30) i 0.0340*** 0.0346*** (11.13) (11.32) Notes: Regression equation: Mt a b0 b jQt j Mt1 T t=90 jSt j et ; where Mt, return rate of arbitrage 1 trading; St, KOSPI returns; |Qt|, trading intensity of trader i. *, ** and *** denote significance at 10, 5 and 1% levels, respectively. The numbers in parentheses are t-statistics.

autocorrelation at a 10% significance level. This implied that individuals did not execute trading towards decreasing arbitrage opportunities. Depending on the weight of the volume of individuals, individuals might increase the arbitrage opportunities. According to our estimates, when the trading intensity of individuals exceeds 66% of the total trading volume, the return rate would increase, resulting in more arbitrage gains. The empirical results suggest that individuals traded in the futures market in the same manner as noise traders. The individuals may buy futures more than spots in contango cases because they recognize the positive margin rates as an indication that the gap between futures and spot prices will widen. Because each trader may influence the behaviour of others, we estimated the coefficients by regressing on the trading intensities of all traders together. The result confirmed that individuals contributed to the continuation of arbitrage opportunities, whereas trading by other traders decreased the arbitrage opportunities. We also analysed the influence of each trader on the return rates in contango and backwardation cases separately. Using dummy variables, contango and backwardation cases were separated, and then the behaviour of each trader was analysed for each group. Except for individuals, all other traders traded towards decreasing the arbitrage opportunities in both

contango and backwardation cases. By contrast, the individual traders contributed to the continuation of arbitrage opportunities in contango cases only. In backwardation cases, the coefficient was negative but insignificant. The asymmetric results show that the character of individuals as noise traders was emphasized in contango cases.

V. Conclusions This study analysed the influence of individual traders on the persistence of arbitrage trading, using futures market data from the KOSPI 200. The individual traders traded towards sustaining arbitrage trading, so that arbitrage opportunities persisted even when arbitrage trading had been executed. In addition, we found that individual traders persisted with arbitrage trading in contango cases only. Why do individual traders trade towards persistent arbitrage opportunities? We postulate that individual traders may trade in a manner similar to noise traders, who are characterized as positive feedback traders. However, this study is not sufficient to support our hypothesis. Further studies are needed to explain why the behaviour of individuals was asymmetric. Nevertheless, this study contributes to explaining the dynamic process of arbitrage trading. Introducing the

Individual traders and persistence of arbitrage trading

behaviour of the individual trader into the process of arbitrage trading, our results suggest why arbitrage opportunities may persist under existing arbitrage trading. In this context, this study helps to close the gap between two approaches, namely studies of arbitrage trading and those using a behavioural approach.

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destabilizing rational speculation, The Journal of Finance, 45, 37995. Figlewski, S. (1984) Hedging performance and basis risk in stock index futures, The Journal of Finance, 39, 65769. Liu, J. and Longstaff, F. A. (2004) Losing money on arbitrage: optimal dynamic portfolio choice in markets with arbitrage opportunities, The Review of Financial Studies, 17, 61141. MacKinlay, A. C. and Ramaswamy, K. (1988) Index-future arbitrage and the behavior of stock index future prices, The Review of Financial Studies, 1, 13758. Miller, M. H., Muthuswamy, J. and Whaley, R. E. (1994) Mean reversion of Standard & Poors 500 index basis changes: arbitrage-induced or statistical illusion, The Journal of Finance, 49, 479513. Neal, R. (1996) Direct tests of index arbitrage models, The Journal of Financial and Quantitative Analysis, 31, 54162. Shleifer, A. and Vishny, R. W. (1997) The limits of arbitrage, The Journal of Finance, 52, 3555.

References
Brennan, M. J. and Schwartz, E. S. (1990) Arbitrage in stock index futures, Journal of Business, 63, s731. Campbell, J. Y., Grossman, S. J. and Wang, J. (1993) Trading volume and serial correlation in stock returns, Quarterly Journal of Economics, 108, 90539. De Long, J. B., Shleifer, A., Summers, L. H. and Waldmann, R. (1990a) Noise trader risk in financial markets, The Journal of Political Economy, 98, 70338. De Long, J. B., Shleifer, A., Summers, L. H. and Waldmann, R. (1990b) Positive feedback investment strategies and

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