Index arbitrage is a subset of

statistical arbitrage In finance, statistical arbitrage (often abbreviated as Stat Arb or StatArb) is a class of short-term financial trading strategies that employ Mean reversion (finance), mean reversion models involving broadly diversified portfolios of securities (h ...

focusing on index components. An index (such as

S&P 500 The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 leading companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices and in ...

) is made up of several components (in the case of the S&P 500, 500 large US stocks picked by S&P to represent the US market), and the value of the index is typically computed as a linear function of the component prices, where the details of the computation (such as the weights of the linear function) are determined in accordance with the index methodology. The idea of index arbitrage is to exploit discrepancies between the market price of a product that tracks the index (such as a

Stock market index future In finance, a stock market index future is a cash-settled futures contract on the value of a particular stock market index. The turnover for the global market in exchange-traded equity index futures is notionally valued, for 2008, by the Bank for ...

Exchange-traded fund An exchange-traded fund (ETF) is a type of investment fund that is also an exchange-traded product, i.e., it is traded on stock exchanges. ETFs own financial assets such as stocks, bonds, currencies, debts, futures contracts, and/or comm ...

) and the market prices of the underlying index components, which are typically stocks. For example, an arbitrageur could take the current prices of traded stocks, calculate a synthetic index value using the relevant index methodology, and then apply an interest rate and dividend adjustment to calculate the "fair value" of the stock market index future. If the stock market index future is trading above its "fair value", the arbitrageur can buy the component stocks and sell the index future. Likewise, if the stock market index futures is trading below its "fair value", the arbitrageur can short the component stocks and buy the index future. In both cases, then the arbitrageur would be exposed to

Basis risk Basis risk in finance is the risk associated with imperfect hedging due to the variables or characteristics that affect the difference between the futures contract and the underlying "cash" position. It arises because of the difference between the ...

if the interest rate and dividend yield risks are left unhedged. In a different example, the arbitrageur can take the current prices of traded stocks, calculate the "fair value" of an ETF (based on its holdings, which are chosen to track the index) and arbitrage between the market price of the ETF and the market prices of the stock holdings. In this scenario, the arbitrageur would use the ETF creation and redemption process to net-out the offsetting ETF and stock positions.

References

Arbitrage Financial markets Mathematical finance {{finance-stub

See also

References