Decimalization and the ETFs and Futures Pricing Efficiency

Abstract

This study investigates the impact of decimalization (penny pricing) on the arbitrage relationship between index exchange-traded funds (ETFs) and E-mini index futures. Our empirical results reveal that subsequent to penny pricing, there is a significant fall in the mean ex-ante arbitrage profit, especially in the cases with higher transaction costs. Using OLS and quantile regressions to control for the influences of changes in market characteristics, we find that the overall pricing efficiency has deteriorated in the post-decimalization period. From the quantile regression analyses, it is found that the pricing efficiency is improved only when an extreme large mispricing signal is observed, implying that due to increased execution risk after decimalization, arbitragers will only execute trades when the expected profit is large enough. These results are consistent with the hypothesis that, due to the lowered market depth and increased execution risks, the introduction of decimalization has in general resulted in weakening the ability and willingness of arbitrageurs to initiate arbitrage trades, which subsequently leads to a reduction in the general efficiency of the cash/futures pricing system.

Keywords: Arbitrage, Decimalization, E-mini futures, ETFs, Pricing efficiency

JEL Classification: G13, G14