ore often than not, futures market activities are cited as being integrally M related to sharp price changes in the traditional equity markets; and while the causal claims may be in dispute, an understanding of the relationship between these two markets has become essential for both the market participant and for the stock market analyst or observer. Understanding these instruments and their relationship to their underlying markets will undoubtedly increase the opportunity to engage in profitable tradinglinvesting.
THE TRADITIONAL THEORY
This note focuses on the price relationship between the Chicago Mercantile Exchange's S&P 500 Futures Contract-the most actively traded stock index futures-and the underlying S&P 500 Index. For the most part, academic literature describes this relationship as being a function of an arbitrage between the traditional equity markets and the futures market. The theoretically correct futures price or "fair value" reflects the cost of carrying an S&P 500 look-alike basket of stocks 'See Cornell (1983), Figlewski (1983, 1984, and 1985), and Modest and Sundaresan (1983). Hansen and Kopprasch (1984) and Stoll (1986) seem to studiously avoid designating the rate as "risk-free". Instead, both characterize the interest rate as a financing rate in a cash and cany arbitrage.