Arbitrage trading and pricing of Municipal bond index futures
The Chicago Board of Trade began trading a futures contract based on The Bond Buyer Municipal Bond Index in June, 1985. Prior to the introduction of this futures contract investors wishing to protect the value of their municipal bond portfolio by hedging were forced to accept the added basis risk of a cross hedge with either Treasury Bill or Bond futures. How useful a futures contract is in transferring risk is dependent on how well the futures price tracks the spot or cash price. How well that is done is dependent upon how quickly and accurately arbitrage can be effected. The forty-bond portfolio underlying the index is revised twice monthly by The Bond Buyer staff. This study addresses the question of the accuracy of arbitrage pricing with the Municipal Bond Index futures contract due to the revision process. It develops pricing models for the upper and lower limits of a no-arbitrage price range within which the futures price may fluctuate without arbitrage being possible.
Data from the first two years of trading the Municipal Bond Index futures contract are used for the empirical analyses. Mean difference t-tests are used to examine the difference in the actual futures contract prices and the theoretical prices calculated by a formula based on the unique Municipal Bond Index futures contract specifications and cost-of-carry futures pricing theory. An added element enters into the study because the U.S. Congress was debating the retroactive removal of the tax-exempt status on municipal bonds during 1986. The uncertainty surrounding the tax treatment of municipal bonds is suspected of affecting the pricing of the bonds and consequently the pricing relationship between the Municipal Bond Index futures contract and the underlying portfolio of municipal bonds. Regression analysis techniques are used to show that the pricing relationship between the futures contract and the bond portfolio is significantly different during the time of the Congressional debate when compared to other time periods. Using a model which accommodates for the effect of the Congressional debate and adjusting for serial correlation in the data with the Yule-Walker technique, the study finds no evidence that the revision process has a significant impact on the pricing of the Municipal Bond Index futures contract.