The impact of soft intervention on the Chinese financial futures market

• Author: Jimmy E. Hilliard,Haoran Zhang
• DOI: http://doi.org/10.1002/fut.22076
• Published date: 01 March 2020
• Date: 01 March 2020

J Futures Markets. 2020;40:374–391.wileyonlinelibrary.com/journal/fut374

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© 2019 Wiley Periodicals, Inc.

Received: 31 July 2019

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Accepted: 6 November 2019

DOI: 10.1002/fut.22076

RESEARCH ARTICLE

The impact of soft intervention on the Chinese financial

futures market

Jimmy E. Hilliard

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Haoran Zhang

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1

Auburn University, Auburn, Alabama

2

Manhattan College, Riverdale, New York

Correspondence

Jimmy E. Hilliard, Auburn University,

Auburn, AL.

Email: jim.hilliard@auburn.edu

Haoran Zhang, Manhattan College,

Riverdale 36849, NY.

Email: hzhang05@manhatten.edu

Abstract

During the 2015 financial crisis in China, participants faced the criticism that

manipulators and shorts had destabilized the market. As a result, the Chinese

Securities Regulatory Commission intervened sequentially in the spot market

and then in the futures market. Trading volume dropped precipitously. Using

the cost‐of‐carry model, we find that these actions significantly impacted

equilibrium pricing. Following intervention in the spot market, mispricing was

attenuated but remained significant after further intervention in the futures

market. We use the Hong Kong market and a difference‐in‐differences statistic

to address the role of the China Securities Regulatory Commission soft

intervention versus intervention by hard rules.

KEYWORDS

Arbitrage, Chinese‐Futures‐Markets, Cost‐of‐Carry, Regulation, Soft‐Intervention

“There was no official announcement, because it hasn’t happened officially, but China just killed the biggest

stock index futures market in the world.—Linette Lopez, senior finance correspondent at Business Insider,

September 9, 2015.”

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INTRODUCTION

Chinese financial futures markets have a relatively short history compared to financial futures markets in other

countries. After unsuccessful pilot projects in the 1990s, the first financial futures contract was formally introduced in

April, 2010. Currently, there are six financial futures index and bond contracts traded on the China Financial Futures

Exchange (CFFEX).

The China Securities Regulatory Commission (CSRC) and the government tightly controlled financial markets in

China.

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The financial futures market is subject to different forms of regulations, including strong implicit threats that

we refer to as “soft intervention.”Instead of a hard ban or rule, soft intervention is a form of regulation in which market

participants do not have formal legal obligations to comply. Rather, the regulator uses implicit threats to affect decisions

made by market participants. Under the state‐controlled financial system, there is evidence to suggest that compliance

by market participants is not optional. Soft regulation shares some features of moral suasion or window guidance in

other markets. However, the consequences of failure to comply are markedly different.

During the 2015 financial crisis in China, participants in the Chinese futures market faced the criticism that market

manipulators and hostile shorts speculated in the bear market through financial futures contracts and thereby

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Li and Zhou (2016) report that the purpose of securities regulation by the CSRC is to advance state policies instead of to protect investors.

destabilized the equity (spot) market (Han & Liang, 2017; Lin 2018; Wildau, 2015). As a result, the CSRC limited short

positions in both the spot and futures markets by soft interventions. Using the volume of transactions and ancillary

information, we date the soft intervention in the spot market in June and the soft intervention in the futures market in

September.

Hilliard and Zhang (2019) tested for violations of equilibrium in the Chinese spot market. They found compelling

evidence that the intervention resulted in significant violations of put‐call parity. This paper tests for violations of

equilibrium between the spot and futures market using the cost‐of‐carry model. We further examine the impact of hard

rule changes versus soft intervention and the impact of sequential interventions in the spot market and then in the

futures market.

Here is a brief summary of our findings. The soft interventions were effective. Short positions in spots and futures

dropped precipitously after the interventions. But there were mispricing consequences. When regulators first

intervened in the spot market, the cost‐of‐carry model revealed that spot indices were significantly overpriced relative to

index futures. Later, similar intervention in the futures market reduced mispricing but spots were still relatively

overpriced.

The paper proceeds as follows: Section 2 reviews the cost‐of‐carry model for index futures. Section 3 describes the

Chinese futures market and data. Section 4 summarizes soft interventions in the Chinese markets and Section 5

discusses the effect of the soft intervention on market efficiency. Section 6 concludes.

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COST‐OF‐CARRY MODEL FOR FINANCIAL FUTURES

Futures contracts are similar to forward contracts. In a forward contract, bilateral participants agree on specifics of the

underlying asset including the size of the contract, the date and time of delivery, and the price to be paid at delivery.

There are no intermediate cash flows. Hull (2015) summarizes the assumptions of the cost‐of‐carry model, (a) all

investors can trade freely without any restrictions, (b) there are no transaction costs, (c) all investors pay the same tax

rate on all net profit, and (d) all investors can borrow and lend freely at the risk‐free rate. Under these assumptions,

financial assets with no or known dividends can easily be priced by the cost‐of‐carry model. Violation of the model

implies the existence of arbitrage profits. The model describes the time trelationship between spot market prices (S)

and the forward (futures) market prices for a contract expiring at time T. The forward price is

FtT S Div e(, )=[ −PV ( )]

,

rT t(−)

(1)

where ris the continuously compounded risk‐free rate and PV(Div) is the present value of dividends received during the

life of the contract.

Futures contracts share many features with forward contracts. However, futures contracts are traded on exchanges

and are typically marked‐to‐market at the end of the trading day. Therefore, interest rate changes can come into play.

For example, if the underlying is positively correlated with interest rates, an increase in rates tends to be accompanied

by an inflow into the long’s margin account. Conversely, a decrease in rates would tend to accompanied by outflows

from the long’s margin account. Under this scenario, the futures contract would have a slightly higher price than a

corresponding forward contract. These differences are usually small, however, and it is typical to assume that futures

contracts are priced like forward contracts. When interest rates are fixed, it can be shown that a futures contract has the

same value as a forward contract.

The cost‐of‐carry model is the established standard for pricing financial futures contracts and used in joint tests of

futures market efficiency. Unlike commodity futures, financial futures have an economically trivial convenience yield.

Therefore, it is easy to show that under standard assumptions violation of the model would produce arbitrage profits.

Cornell and French (1983a, 1983b) summarize the cost‐of‐carry model for index futures and discuss the role of

dividends, interest rates, and taxes. Cornell (1985) finds the cost‐of‐carry model fails in an index futures market by

documenting deviations from the model with a daily data set of S&P500 index prices and futures prices. Conversely,

Chung (1991) provides empirical evidence supporting the cost‐of‐carry model with a transaction‐level data set.

Hull (2015) argues that the short‐sale constraint should not have an impact on the cost‐of‐carry model as long as

some investors own enough shares and are able to sell them if there is an arbitrage opportunity. However, some

empirical studies document the impact of the short‐sale constraint on the spot–future relationship and the cost‐of‐carry

HILLIARD AND ZHANG

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