A new futures contract to remove various problems of plain futures contracts

What is it about?

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 phenomenon common in the U.S., the U.K., 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. Index arbitrage and price manipulation are seen as the culprits here. Since price manipulation is difficult to prevent or detect and index arbitrage is likely to remain popular, plain vanilla futures will be subject to expiration day effects in the future, too. 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 various needs of hedgers. Third, we explore their characteristics as a financial instrument such as their volatilities or expected values. In addition, investors might welcome average price forward or futures contracts since these contracts have other good qualities.Specifically, i) they help investors hedge a risk over a period, ii) they cost less, iii) they allow investors to hedge more flexibly, and iv) they can provide a new investment opportunity for speculators. The first benefit of average price futures comes from the fact that some investors want to hedge their risk over a period, not over-night. The second benefit of average price futures contracts can be cost reduction and efficiency. If an exporter (importer) wants currency forward contracts for “n” different maturities, he should enter into a (plain vanilla) forward contract with a counterparty, mostly a bank, n times. But, if he chooses an average price forward contract, which has n reference dates, he can only enter into one forward contract once and can reduce the cost (of risk transfer) to 1/n times. Average price futures can be a new investment opportunity for speculators, too. Suppose you are a speculator. Unless you are an extremely self-confident fortune teller, you will not easily bet your money on the price of a futures contract on Dow Jones Industrial Average on its expiration day. It is because you have to speculate on the futures’ price at a certain point of time. However, speculating on an average of prices over a month, a quarter, or a year can be much more feasible.

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Why is it important?

First and foremost, average price futures contacts prevent price manipulation or alleviate impact of index arbitrage. Secondly, the following four things can help a range of investors increase their utilities by investing in these futures: i) they help investors hedge a risk over a period, ii) they cost less, iii) they allow investors to hedge more flexibly, and iv) they can provide a new investment opportunity for speculators.

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