Since their introduction in the early 1980s, stock index futures have been extremely successful. One reason for the success is that stock index futures allow investors to trade market risks and manage risk exposures. Stock index futures markets attract three broad types of traders: hedgers, speculators, and arbitrageurs. Hedgers use the index futures contracts to manage the risk in an equity index portfolio. Speculators use them to bet on the future direction of the index. Arbitrageurs take offsetting positions in the futures and the index stocks to lock in a profit.

The classical economic rationale for futures markets is that they facilitate hedging. For example, a fund manager can use stock index futures to reduce risk in the fund portfolio over a long time horizon. However, hedging benefits come with costs that can be either explicit costs or implicit costs. Explicit hedging costs are brokerage commissions and exchange fees. Implicit costs include the premium a hedger is paying to counterparties when setting up their hedging positions. This project will identify who the hedgers are, and estimate their costs of hedging.

The researchers of this project also aim to identify the suppliers of hedging. Speculators may take the other side and trade with hedgers. Market makers provide liquidity and are also likely suppliers of hedging. Due to their ability to trade with ultra-low latency, HFTs do business as market makers, arbitrageurs, and speculators. Thus, HFTs are likely to be the counterparties to hedgers. The project will investigate if HFTs are able to time hedging demand, influence the cost of hedging, and earn the hedging pressure premiums. HFT is a common scapegoat when markets fail, but it is a highly diverse set of trading strategies. The project can add to the understanding of HFTs, which makes for a more nuanced policy debate.

Arbitrageurs take advantage of price discrepancies in the stock market and in the index futures market. Arbitrage is a double-edged sword. When frictions, such as inventory or short-selling costs, break down the law of one price, the arbitrage is non-toxic in the sense that arbitrageurs can provide liquidity and improve market efficiency by easing price pressures. However, when prices are briefly uncoordinated due to information arrivals, arbitrage is toxic to market makers that are slow in revising their quotes. In this case, market makers respond to toxic arbitrage by widening the bid-ask spread, and, thus, worsening futures market quality. The researchers of this project will identify the index futures arbitrageurs, and analyze whose futures arbitrage activities are toxic and, thus, who actually deteriorates futures market quality.

How can we reconcile the activities of the different types of futures traders into one theoretical framework? One idea is that the market microstructure invariance (MMI) theory does the job. It stipulates that the distributions of risk transfers and transaction costs are constant over trading time. Another idea is to translate the MMI into an intraday trading invariance (ITI) theory, in which the assumption is that the volatility per trade is proportional to expected trade size. The intuition is that traders trade more often, and in smaller lots, when the volatility is high. The project analyzes how well these theories stand up in a futures hedging demand-supply framework, with, on the one hand, long-term investors with hedging needs, and, on the other hand, HFTs and other liquidity suppliers with intraday trading horizons. In particular, the project studies the relationship between volatility and trade size at times when futures hedging pressure is large. It is expected that an increased hedging pressure will create higher transaction costs than predicted by the MMI and the ITI.

Project time



The Jan Wallander and Tom Hedelius foundation, and the Tore Browaldh foundation (SEK 2 million). The Nasdaq Nordic Foundation (SEK 553,500).


Lars Nordén, Petter Dahlström, Björn Hagströmer, Ai Jun Hou, and Caihong Xu.


Lars Nordén