Order Imbalance and the Dynamics of Index and Futures Prices

This study examines empirically with complete transaction records of index futures and of the index stocks, as well as the bid/ask price quotes of the latter, the impact of stock market order imbalance on the dynamic behavior of index futures and the underlying cash index. The study purges spurious correlation in the index by using an estimate of the “true” index with highly synchronous and active quotes of individual stocks. To capture the nonlinear dynamics of the index and futures prices, the study adopts a smooth transition autoregressive error-correction (STAR) process to model the joint dynamics between the two prices. The study finds that order imbalance in the cash stock market significantly affects the error-correction dynamics of index and futures prices. Moreover, order imbalance impedes error-correction when the two forces countervail each other. This finding supports our conjecture that order-imbalance helps explain why real potential arbitrage opportunity may persist over time. The results also show that incorporating order imbalance in the STAR model significantly improves the explanatory power of the framework. Furthermore, the speed of transition increased substantially for the cash index during the crisis period. It can be inferred from the findings that stock market microstructure which allows a speedy resolution of order imbalance promotes dynamic arbitrage efficiency between the futures and the underlying cash stocks.