Program Trading and the Link Between the Spot and Futures Prices

Program trading has been identified as a mechanism that links the futures and spot markets. It has also been identified as a potential cause of market instability leading to regulations on program trading during volatile markets. Program trading halts provide a natural experiment to test the hypothesis that program trading is an important mechanism that maintains relative market pricing. This study is the first to analyze the effect of removing all program trades on the connectedness of the spot and futures markets during large market moves. The Korean regulatory environment has several unique properties that lend itself to such a study. Overall, we provide evidence that (i) the basis is unaffected when program trading is eliminated during large market moves, (ii) arbitrage exists and appears to be able to identify uninformed price moves, (iii) the data do not support the argument that halts provide a time-out period in order for markets to reevaluate information, and (iv) there are costs associated with imposing trading halt regulations on financial markets.