An Analysis of the Implications for Stock and
Futures Price Volatility of Program Trading
The introduction of futures and options markets in stock indexes is strongly associated with the use of programmed trading strategies. Such strategies are used for spot/futures arbitrage, market timing, and portfolio insurance. It is this last use of programmed trading strategies that raises fascinating theoretical questions, the answers to which may have practical importance for understanding the impact of such strategies on the volatility of stock and futures prices.
Recent advances in financial theory have created an understanding of the environments in which a real security can be synthesized by a dynamic trading strategy in a risk free asset and other securities (The seminal contribution is the Black-Scholes [1973] option pricing approach, whereby it is shown how a dynamic trading strategy in a stock and risk free asset can reproduce a European call or put option on the stock). The proliferation of new securities has been made possible, in part, by this theoretical work. The issuer of a new security can price the security based on its ability to synthesize the returns stream of the new security using a dynamic trading strategy in existing securities, futures and options. This use of dynamic trading strategies has been extended even further by eliminating the "new" security altogether and just selling the dynamic hedging strategy directly. Portfolio insurance is the best example of the latter phenomenon.
Herein we contend that there is a crucial distinction between a synthetic security and a real security. In particular the notion that a real security is redundant when it can be synthesized by a dynamic trading strategy ignores the informational role of real securities markets (see Grossman [1977] for an elaboration of the informational role of securities and futures prices). The prices of real securities convey importan...