A Model of Stock Index Security Trading: Information, Volume and Pricing

This paper develops a model of trading in stock and stock index security markets in the presence of transaction costs. We show that the introduction of stock index market improves the dissemination of market-wide information and index trading is more informative about stock market price movements than stock trading. The model generates rich implications on the informativeness of the stock index price, the causes and consequences of index arbitrage and the bi-directional lead-lag relation between the index and the stock markets. The implications of the model are tested using S&P 500 index options data. ∗The Ohio State University, Department of Finance, College of Business, 2100 Neil Avenue, Columbus, OH 43210, Tel: (614) 292-7562. Email: [email protected]. I am grateful to David Hirshleifer, Ingrid Werner and Anthony Sanders for valuable suggestions and criticisms. I thank Jim Hsieh and Christo Pirinsky for discussions and participants in the Finance Department Seminar for helpful comments.