Average Price Futures Contracts: Pricing, Characteristics, and Implications

• Author: Jin Yoo
• DOI: http://doi.org/10.1111/ajfs.12115
• Published date: 01 December 2015
• Date: 01 December 2015

Average Price Futures Contracts: Pricing,

Characteristics, and Implications*

Jin Yoo**

College of Economics and Finance, Hanyang University

Received 25 April 2015; Accepted 23 October 2015

Abstract

We define and price average index and currency futures, show how they reduce price manip-

ulation, explore their features as financial instruments, and discuss their policy implications.

They offer investors protection against price manipulation, effective hedging, and even

rational speculation. The study shows that the mean and variance of the price of an arith-

metic average futures contract are functions of its reference dates and that it can be flexibly

designed to meet diverse hedging needs of investors. With these features, average price

futures contracts can serve as a good complement to existing plain vanilla futures.

Keywords Average price futures; Futures pricing; Expiration day effects; Price manipulation;

Reference dates

JEL Classification: G13, G14

1. Introduction

In the Korea Exchange, a shocking incident occurred on November 11, 2010, the

expiration day of the monthly-expiring KOSPI 200 options, the underlying asset of

which is the Korea Stock Price Index 200 or the KOSPI 200. The KOSPI 200 plum-

meted from 254.62 to 247.51 in the closing call auction of the stock market, down

2.79% in less than 10 minutes. Later it was revealed that a large foreign institutional

investor sold off almost all of its Korean stocks worth 2.5 billion US dollars during

the closing call auction in order to push stock prices down and profit as much as

possible from its long position in the put options on the index. As a result, 28 bil-

lion US dollars of the Korean stock market capitalization vanished in less than

10 minutes, and numerous investors in stocks, index futures and index options suf-

fered huge losses, whereas the foreign institution allegedly earned approximately

500 million US dollars. This incident has been closely investigated by the Financial

*I thank two anonymous referees for their valuable comments. This work was supported by

the research fund of Hanyang University (HY-2013).

**Corresponding author: Jin Yoo, College of Economics and Finance, Hanyang University,

222 Wangsimni-ro, Seongdong-gu, Seoul 04763, Korea. Tel: +82-2-2220-1026, +82-10-8121-

3902, Fax: +82-2-2296-9587, email: jyoo@hanyang.ac.kr.

Asia-Pacific Journal of Financial Studies (2015) 44, 849–876 doi:10.1111/ajfs.12115

©2016 Korean Securities Association 849

Supervisory Service of Korea, the financial market watchdog in Korea, and the

Korea Exchange for years but it becomes clear that to bring the culprits of the inci-

dent, mostly foreigners, to justice is extremely difficult and unpromising.

Stock prices often undergo high volatility or reversals on or around expiration

days of index futures or options. This “expiration day effect” has been a phe-

nomenon common in the US, the UK, Germany, Canada, Spain, India, Taiwan,

and Norway, and is used to account for the flurry of activity such as price reversals

or excessive volatility of stock prices as traders of futures and options unwind their

positions around their expiration days.

1

Index arbitrage and price manipulation are

seen as the culprits here (Stoll and Whaley, 1997; Alkeb€

ack and Hagelin, 2004;

Hsieh, 2009; Hsieh and Ma, 2009). Since price manipulation is difficult to preven t

or detect and index arbitrage is likely to remain popular, plain vanilla futures will

be subject to expiration day effects in the future, too.

Emerging markets like Korea might face additional difficulties in alleviating

those effects. For instance, it is easier to manipulate or influence the KOSPI 200

successfully than the S&P 500 or the FTSE 100 index since the size and the overall

regulation of the Korean market or a typical emerging market are much smaller

and less restrictive than those of a developed market. In fact, foreign investors with

more money and discretion have been winners in the Korean derivatives or stock

market for decades in terms of information, trading strategy, performances, and

reputation, and can be very powerful in influencing stock or futures prices (Kang

and Ryu, 2010; Yoo, 2011; Ko, 2012; Ryu, 2015). Besides, the settlement price at

expiration of the KOSPI 200 futures has been a closing price since its inception in

1996, which is generally perceived to be more susceptible to expiration day effects

than an opening or an average settlement price is. As the settlement price of a

futures market is not likely to be changed quickly, expiration day effects in the mar-

kets of closing prices will not be mitigated to an acceptable level soon.

2

Average settlement prices, however, are more difficult to manipulate: we find

that the impact of manipulation sharply decreases as the number of reference dates

increases. In relation to this, the purpose of this paper is three-fold. First, we define

and price average price futures contracts. Second, we examine the unique features

of these futures contracts such as reducing expiration day effects and meeting vari-

ous needs of hedgers. Third, we explore their characteristics as a financial instru-

ment such as their volatilities or expected values.

1

Refer to Stoll and Whaley (1987), Chamberlain et al. (1989), Pope and Yadav (1992),

Swindler et al. (1994), Schlag (1996), Vipul (2005), Illueca and Lafuente (2006) and Hsieh

(2009).

2

For reference, even an opening settlement price has not always been working satisfactorily

against expiration day effects in terms of volume (Karolyi, 1996; Schlag, 1996), volatility

(Hancock, 1993; Chen et al., 1999), or price reversal (Schlag, 1996). In contrast, average price

settlement has been functioning relatively well against those effects (Schlag, 1996; Stoll and

Whaley, 1997; Chow et al., 2003; Alkeb€

ack and Hagelin, 2004; Chung and Hseu, 2008).

J. Yoo

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