This thesis examines the validity of the cost of carry model for pricing FTSE100 futures contracts and the relationship between FTSE100 spot and futures markets during two
sub-periods characterised by different market trading systems employed by the LSE
and LIFFE. The empirical work is carried out using three approaches to econometric
modeling: a basic VECM for spot and futures prices, a VECM extended with a DCCTGARCH
framework to account for the conditional variance-covariance structure for
spot and futures prices and a threshold VECM to capture regime-dependent spot-futures
Overall, both the basic VECM and the DCC-TGARCH analysis suggest that there are
deviations from the cost of carry relationship in the first sub-sample when transactions
costs in both markets are relatively high but that the cost of carry relationship tends to
be valid in the second sub-sample when transactions costs are lower. This is further
confirmed by the evidence of higher conditional correlations between the two markets
in the second sub-sample as compared with the first, using the DCC-TGARCH analysis.
This implies that the no-arbitrage cost of carry relationship between spot and futures
markets is more effectively maintained by index arbitrageurs in the second period when
market conditions are closer to perfect market assumptions, and hence the cost of carry
model could be more reasonably used as a benchmark for pricing stock index futures.
The threshold VECM analysis depicts regime-dependent price dynamics between
FTSE100 spot and futures markets and leads to some interesting and important findings:
arbitrage may not be practicable under some market conditions, either because it is
difficult to find counterparties for the arbitrage transactions, or because there is
significant risk associated with arbitrage; as a result, the cost of carry model may not
always be suitable for pricing stock index futures. Furthermore, the threshold values
yielded from estimating the threshold VECM reflect the average transaction costs for
most arbitrageurs that are more reliable and fair than subjective estimations.
A Doctoral Thesis. Submitted in partial fulfillment of the requirements for the award of Doctor of Philosophy of Loughborough University.