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Liquidity and transactions costs of Asia-Pacific stock index futures

Date 29/10/2008

Alex Frino, Andrew Lepone and Jeff Wong, University of Sydney and Mike Aitken, University of NSW

There are numerous studies that compare liquidity and transaction costs for international equity markets. However, international comparisons of transaction costs in futures markets are virtually non-existent. As money managers worldwide hold portfolios of securities from various markets, their choice of a futures contract for hedging or investment purposes is not restricted to one particular market.

This article compares trading opportunities offered by the ten most actively traded stock index futures contracts in the Asia-Pacific region. We compare the price volatility and liquidity (including transaction costs) of the futures contracts, evaluating market impact costs, the bid-ask spread, depth and trade value, volatility and US dollar notional turnover. The analysis draws on data obtained from Reuters for the period 1 January 2003 to 31 December 2007 for daytime trading only. Any trades that meet the minimum requirement for off-market block transactions are excluded from the sample.

Transaction costs

Transaction costs are an important consideration for global institutional investors. One important transaction cost is the on-market cost of trading (market impact), which is incurred through the execution of large trades. Market impact is a function of both the bid-ask spread and depth. The bid-ask spread represents the minimum cost of trading futures, and sufficient depth at the best quotes allows investors to trade large quantities with minimal price impact. It is well documented that wide spreads and low depth erode institutional profits from trading strategies. To compare transaction costs across contracts, we report the on-market cost of trading (market impact), bid-ask spread, depth at the best bid and ask, and average trade value for each contract.

Market impact cost

Market impact is an on-market cost of trading, and is defined as the extent to which a large trade adversely affects the futures price. That is, the extent to which a large buy trade moves the futures price upwards, and the extent to which a large sell trade moves the futures price downward.

To measure market impact for each trade, we first select a benchmark price independent of the trade which is the price five trades prior to the trade. Market impact is measured as the percentage return from the benchmark price to the trade price. If the trade price is greater than the benchmark price for purchases, or less than the benchmark price for sales, then the trade has incurred market impact costs. The level of market impact depends on the magnitude and direction of the price pressure exerted by the trade.

To compare market impact costs across contracts, the notional value of each trade is calculated in US dollars and trades are assigned to size-groups based on their US dollar value. The largest 10% of trades are sorted into four (approximately) equal groups. An additional group is added to capture extremely large trades greater than USD10m in notional value.

Figure 1 shows the average market impact costs incurred by transactions in the most active stock index futures contracts in the Asia-Pacific. As expected, market impact increases as the notional value of the trade increases. Average market impact costs for the largest trades in the Nikkei 225 (Singapore) and Hang Seng futures are no larger than 0.0105% for all trade sizes. Trades in the SPI200, MSCI Taiwan, Kospi200 and MSCI Singapore incur only marginally higher market impact. The statistics presented in Figure 1 show that trading strategies using various stock index futures contracts in the Asia-Pacific region incur very low market impact costs.

Figure 1: Average market impact costs incurred by different-sized trades

Bid-ask spreads

The bid-ask spread measures the round-trip cost of a transaction. In order to assess the extent to which stock index futures in the Asia-Pacific region are likely to present profitable trading opportunities to investors, we compare bid-ask spreads for each stock index futures.

Figure 2 reports average percentage bid-ask spreads for all contracts, calculated as [(Best ask – Best bid) / Midpoint]*100. Hang Seng futures incur an average round-trip cost of approximately 0.014%. Bid-ask spreads in SPI200, Taiex, Nikkei 225 (Singapore), MSCI Taiwan and MSCI Singapore futures are all lower than 0.04%. Results presented in Figure 2 illustrate that stock index futures contracts in the Asia-Pacific region have very low percentage bid-ask spreads.

Figure 2: Bid-ask spreads

Depth and trade value

Depth and average trade value provide additional indicators of trading opportunities available to investors. To assess the extent to which stock index futures contracts in the Asia-Pacific region presents profitable trading opportunities to investors, we compare average depth at the best quotes and average trade value for stock index futures in the Asia-Pacific region. We report depth and average trade value in US dollars to compare across markets.

Figure 3 reports average depth at the best quotes and average trade value for all contracts. Contracts are ranked based on available depth. Depth in Nikkei 225 (Tokyo) at the best bid and offer is approximately USD45m. Depth at the best bid and offer in the Kospi200, Topix and Nikkei 225 (Singapore) are all above USD5m. All ten contracts have sufficient depth at the best bid and offer to accommodate the average sized trade.

Figure 3: Depth at best bid/offer

Volatility

An additional consideration for investors is contract volatility. The expected profitability of a futures position increases when a contract is more volatile over the investor’s trading horizon. In order to assess the extent to which the ten Asia-Pacific stock index futures provide profitable trading opportunities, price volatility is calculated and compared using the ‘True Range’ volatility measure, which is calculated as the maximum of the (|closet-1 – lowt|,|hight – closet-1|,|hight – lowt|). This has been converted into currency values and divided by the margin for each contract.

Figure 4 compares the average daily volatility (true range) for each contract in the sample. Volatility in the Topix, MSCI Singapore, Taiex and Nikkei 225 (Singapore) is all above 25%, while volatility in the H-Share, Hang Seng, SPI200 and MSCI Taiwan range between 20-25%. Results in Figure 4 suggest that significant profit making opportunities exist in the Asia-Pacific stock index futures.

Figure 4: Price volatility

US dollar notional turnover

When comparing trading opportunities offered by stock index futures, another consideration for global institutions is liquidity. The liquidity of a contract is related to the cost of trading, and directly affects the profitability of a futures trade. Two indicators of contract liquidity are average daily contract volume and average daily USD notional turnover.

All stock index futures contracts examined are ranked in Table 1 according to average daily notional turnover in US dollars. Both the KOSPI 200 and Nikkei 225 (Tokyo) have average daily notional turnover in excess of USD4bn, while both the Hang Seng and Topix have average daily notional turnover in excess of USD1bn. While the other contracts have lower daily turnover, there is significant trading activity in all Asia-Pacific contracts examined in this study.

Table 1:  US Dollar Notional Turnover (Excluding Off-Market Block Transactions)
  Exchange Average daily volume* Average daily notional turnover *(USD)
KOSPI 200 KSE 179,066.40 6,725,894,179.13
Nikkei 225 OSE 35,129.59 4,106,068,145.32
Hang Seng HKE 17,067.86 1,186,422,468.50
TOPIX TSE 10,034.91 1,013,092,280.28
TAIEX TFE 22,667.01 806,845,961.48
Nikkei 225 SGX 51,809.70 935,642,422.59
SPI 200 SFE 9,345.20 646,784,615.63
MSCI Taiwan SGX 19,039.61 495,790,290.05
H-Share ** HKEx 4,352.17 140,065,959.72
MSCI Singapore SGX 1,710.72 41,697,388.89
* Excludes trades that meet the minimum threshold for off-market block transactions
** Began trading December 8, 2003

Alex Frino is Professor of Finance at the University of Sydney and Chief Executive Officer of the Capital Markets Cooperative Research Centre
Mike Aitken is Professor of Finance at the University of NSW and Chief Scientist of the Capital Markets Cooperative Research Centre
Andrew Lepone is Senior Lecturer at the University of Sydney
Jeff Wong is a PhD Candidate at the University of Sydney