The search for liquid hedging instruments in China's stock market

Financial professionals and scholars generally agree that the two most important transaction types found in global stock futures markets are arbitrage and calendar spreads¹. Of these, arbitrage is the more important, especially in newly developing futures markets such as China and India. It is also widely agreed that sustaining a meaningful volume of daily arbitrage transactions is required for the successful growth of futures exchanges. Yet very little is written in detail about the important practical elements of implementing these crucial trades, knowledge of which regulators, investors and exchange officials must have as they seek to develop and participate in efficient equity markets.

The function of continuous stock index arbitrage between futures and their underlying assets is to exert necessary pricing pressure that causes futures prices to revert to their economic fair value. Lack of a central fair value price both reduces liquidity in futures and stock markets and erodes the corresponding willingness of individuals and institutions to participate. Without a fairly priced index futures market, institutional investors, both domestic and foreign, have few means to hedge their diversified stock portfolios when risks are perceived to be high. Typically, the only alternative is to liquidate assets in times of risk: normally an very expensive process. Experience reveals that the absence of hedging instruments especially limits foreign investments and can lead to significant outflows of capital in times of distress. Especially in newly developing futures markets, it is therefore important for regulators and exchanges to create and sustain trading rules, tax levels, margins and other conditions conducive to arbitrage

Also affected by a lack of efficient arbitrage is the ability of managers to develop and offer dependable product innovations based upon derivatives². The presence of financial instruments effective for hedging and for new product development can not only encourage needed foreign capital flows but also stabilise foreign capital already invested in developing economies. These facts explain the desire in emerging markets to rapidly develop derivative markets in parallel with domestic stock markets.

China’s government, for example, has recognised this issue and accelerated the growth of its stock index futures market listed on the China Financial Futures Exchange (CFFEX). In May 2011 Zhu Yuchen, President of the CFFEX, cited a resolution contained in the third round of China-US Strategic Economic Dialogue to create and encourage a QFII (Qualified Foreign Institutional Investor) presence in the China stock index futures market. The Chinese government and the city of Shanghai also seek a common goal of making Shanghai a premier global financial centre by 2020. Obtaining that goal will require attention to be focused on the health of the city’s financial futures market and so to measures supporting the pursuit of successful index arbitrage activities. With the size of China’s stock market second only to that of the US, investors should reasonably expect China’s stock index futures market to follow shortly.

Using recent CSI 300 futures data, this article seeks to explore specific details of stock index arbitrage in China’s new CSI 300 stock index futures market. Knowledge of the requirements for successful arbitrage in this market can suggest to regulators and exchanges the steps necessary for making market improvements that can attract and retain foreign and domestic professional investors. Meanwhile, knowledge of the practical means for identifying and implementing profitable arbitrage can encourage the professional growth of an essential activity that improves market liquidity and stability. Finally, the understanding that index arbitrage is serving to keep futures prices near to their economic fair value can also provide investors and hedgers with the assurance they need to increase comfortably their participation in China’s rapidly developing stock market.

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