Index arbitrage gaining momentum in Asia

Rising index arbitrage activity in Asia will add liquidity to the region's equity markets and create a healthy environment for the cross-listing of indexes between bourses, market participants say.
By None

Rising index arbitrage activity in Asia will add liquidity to the region's equity markets and create a healthy environment for the cross-listing of indexes between bourses, market participants say.

Hani Shalabi, head of Advanced Execution Services, Asia Pacific, at Credit Suisse, notes growing arbitrage opportunities across Asia, most notably in the markets of Japan, Hong Kong, Singapore and Australia. “Index arbitrage tends to keep the prices of index futures where they should be by taking away inefficiencies in the market. These traders are adding to liquidity because once they get a signal to buy or sell, they will execute the whole basket. This is unlike some other high-frequency strategies that send a lot of orders to market but execute only a small portion,” he said.

Popular strategies include taking advantage of price differentials between stock index futures, such as those on the Nikkei 225 futures on the Osaka Securities Exchange (OSE), and the underlying basket of stocks on the Tokyo Stock Exchange. Arbitrage activity on Nikkei 225 futures between the OSE and the Singapore Exchange (SGX), and on the Nifty between India's National Stock Exchange and SGX has also been on the rise. Another type of index arbitrage involves exploiting the differential between the net asset value of exchange-traded funds (ETFs) and the underlying share prices.

Anshuman Jaswal, senior analyst, capital markets at research firm Celent and author of a new report, ”Electronic Trading in Asia-Pacific', expects index arbitrage to increase in Asia as technology becomes more advanced. “Index or similar arbitrage strategies are certainly positive for the market, and will rise with more electronic trading in Asia. They bring liquidity and depth to the market. However, we still need to have the appropriate risk management mechanisms in place, as with any other form of trading,” he said.

Jaswal also noted that increasing opportunities for arbitrage by hedge funds between the US and Asian markets for American Depository Receipts (ADRs). SGX is about to launch an international board primarily trading ADRs in 19 Asian companies. The board, to be named GlobalQuote, is due to open on October 22 in co-operation with Nasdaq OMX and the Bank of New York Mellon, which will act as the depositary bank.

“Index arbitrage and neutral asset investment are two of the more favored strategies for algorithmic trading. At present, the region is still in the early adoption stage for algorithmic trading, but these strategies are already quite popular. But innovation is increasing, and traders are willing to take more risks,” Jaswal remarked.

In theory, the more liquid and efficient markets are, the fewer arbitrage opportunities they present. In practice, however, arbitrage opportunities will always exist given that exchanges operate differently and trading practices differ across markets. “The dual listed indexes should be at the same price. But price differentials can exist because of, say, different price increments on different exchanges. For example, the OSE has 10-yen increments and SGX has five-yen increments. They are very rarely misaligned but since they are separate and independently listed products, the arbitrageurs are keeping the prices balanced,” said Shalabi. “There are also variables in the pricing of index futures. For example, some companies announce dividends quarterly, and some half yearly and what the dividend is going to be is not guaranteed. So there’s a fair amount of guess work which is why price differentials exist.”

The Tokyo Stock Exchange (TSE) is also “very keen” to provide index arbitrage opportunities, according to Tomoyoshi Uranishi, senior executive officer. “Index arbitrage trading has been very popular in the US, and we are very keen to accommodate such trades providing necessary information. There are various index futures, options and index ETFs on the TSE. We hope more active index arbitrage trade will be made among them,” he said.

Celent's Jaswal notes that TSE's Arrowhead trading platform has already led to an increase in the local adoption of high-frequency trading strategies and he expects more high-frequency and statistical arbitrage trading between alternative venues in the Japanese equities markets. The Osaka Securities Exchange will move its futures and options trading engine to Tokyo in 2011, enabling firm to get lower latencies when trading derivatives.