Stock Index Futures and Index Arbitrage in a Rational Expectations Model

This article analyzes the role of stock index futures and index arbitrage in a rational expectations economy with competitive stock and futures markets. A simple model is developed with three types of agents who, besides having different trading motives, have unequal access to markets. Among these agents, only index arbitrageurs can trade on both markets and thus engage in arbitrage. The article characterizes the impact of index arbitrage on equilibrium prices, volatilities, and welfare. It is shown that index arbitrage is a risk-reallocating and price-correcting mechanism. Its impact on price stability is shown to be dependent on the relative variability of aggregate supply in the respective markets. Index arbitrage also transmits information across markets.