Inter-market linkages : a study of the relationship between the bank bill and the bank bill futures markets in New Zealand

by Poskitt, Russell

This thesis examines the linkages between the bank bill market and the bank bill futures market in New Zealand using intraday data. The thesis is motivated primarily by the dearth of research on inter-market linkages in interest rate markets using high frequency data. The thesis examines four aspects of the inter-market linkage: (i) the pricing of the bank bill futures contract; (ii) inter-market arbitrage opportunities; (iii) evidence of arbitrage activity, and (iv) inter-market information transmission. The key to the empirical work on these four issues is a model of bill futures pricing developed using the no-arbitrage approach and an intraday data set provided by Reuters and the New Zealand Futures and Options Exchange. The empirical work yields the following findings:

• the implied forward rate (IFR) model performs well in pricing the bill futures contract. The futures/IFR differential is negligible compared to that documented in many prior studies. The performance of the IFR model is attributed to the fact that it mirrors the favoured quasi-arbitrage strategies of the price-setting interbank dealers.

• quasi-arbitrage opportunities are infrequent and substantially less profitable than prior studies report. This is also the case when the stringent requirements for conventional arbitrage are relaxed. The frequency and profitability of quasi-arbitrage opportunities are on a par with those reported in the stock index futures and foreign exchange markets.

• arbitrage opportunities exert only a weak equilibriating influence on the bill futures yield, suggesting that arbitrage activity plays little formal role in price-setting in the bill futures market.

• information transmission between the bill and bill futures markets is dominated by the contemporaneous flow of information between the two markets and the lagged flow of information from the bill futures market to the bill market. This is consistent with the proposition that bill dealers base their quotes on the bill futures yield curve.