Investments, tenth edition

23.4 

  Index Arbitrage 

 Whenever the actual futures price falls outside the no-arbitrage band, there is an opportu-

nity for profit. This is why the parity relationships are so important. Far from being theo-

retical academic constructs, they are in fact a guide to trading rules that can generate large 

profits.    Index  arbitrage    is an investment strategy that exploits divergences between the 

actual futures price and its theoretically correct parity value. 

 In principle, index arbitrage is simple. If the futures price is too high, short the futures 

contract and buy the stocks in the index. If it is too low, go long in futures and short the 

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stocks. You can perfectly hedge your position and should earn arbitrage profits equal to the 

mispricing of the contract.  

 In practice, however, index arbitrage presents challenges in implementation. The prob-

lem lies in buying “the stocks in the index.” Selling or purchasing shares in all 500 stocks 

in the S&P 500 is impractical for two reasons. The first is transaction costs, which may 

outweigh any profits to be made from the arbitrage. Second, index arbitrage calls for the 

purchase or sale of shares of 500 different firms simultaneously, and any lags in the execu-

tion of such a strategy can destroy the effectiveness of a plan to exploit temporary price 

discrepancies. Don’t forget that others also will be trying to exploit any deviations from 

parity, and if they trade first, they may move prices before your trade is executed. 

 Arbitrageurs need to trade an entire portfolio of stocks quickly and simultaneously 

if they hope to exploit disparities between the futures price and its corresponding stock 

index. For this they need a coordinated trading program; hence the term    program  trading,      

which refers to purchases or sales of entire portfolios of stocks. Electronic trading enables 

traders to submit coordinated buy or sell programs to the stock market at once.  

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 The success of these arbitrage positions and associated program trades depends on 

only two things: the relative levels of spot and futures prices and synchronized trading in 

the two markets. Because arbitrageurs exploit disparities in futures and spot prices, 

absolute price levels are unimportant.