Degree of market imperfection and the pricing of stock index futures

Capital markets are imperfect. Market imperfections differ among markets. This study uses a theoretical valuation model derived by Hsu and Wang (2004) to estimate the degrees of market imperfection for mature and immature markets, and tests the applicability of the model. Moreover, this study proposes some theoretical hypotheses and empirical tests regarding the relationship between the degree of market imperfection and futures pricing. The evidence indicates that the Hsu and Wang (2004) model appears to provide a reasonable measure of the degree of market imperfection for real capital markets. The theoretical hypotheses and empirical results indicate that larger market imperfections are relatively more mispriced based on the model of perfect-market assumption, suggesting that the impact of market imperfection on the pricing of stock index futures is enormous, and cannot be neglected. Thus, when investors more closely examine the applicability of the cost of carry model for pricing mature and immature futures markets, they should note the degree of imperfection for the markets in which they are participating.