Trading strategies based on the lead-lag relationship between the spot and the futures prices for the Nikkei 225 Stock Average Index

Abstract

The main objective for this master thesis was to investigate the relationship between the spot and futures market for the Nikkei 225 Stock Average Index, in order to give an indication about the efficiency of the Japanese financial markets. Furthermore, the sample period from July 2004 to July 2014 provided an opportunity to compare the nature of the relationship before and after the financial crisis of 2008. The focus of the study was the following research question: Is it possible to earn an abnormal return in the Japanese market, as represented by the Nikkei 225 Stock Average Index, by trading in the spot and futures market based on an error correction model? The efficient market hypothesis and arguments concerning arbitrage formed the theoretical foundation of the study. The relationship between the spot and the futures market for the Nikkei 225 Stock Average Index was investigated using unit root tests, the Engle and Granger two-step co-integration method, error correction models and ARIMA frameworks. The study showed that the two prices were co-integrated and shared a long-run relationship. A Granger causality test suggested that the relationship was bi-directional, with a strong feedback effect. Furthermore, the study uncovered a shift in the relationship from the period before September 15th 2008 to the period after. The results implied that the flow of information had slowed down, and that corrections back to the equilibrium state were slower, and therefore a deterioration of market efficiency. The models were tested further using forecasting techniques on out-of-sample periods. The best models from the post financial crisis period were applied in a test of different trading strategies. The selection of models was based on RMSE (root mean squared error), MAE (mean average error) and percentage of correct prediction of direction. None of the active strategies provided abnormal profits after the deduction of transaction costs. This was the case for both trade of futures contracts and trade of the spot price. Therefore, the market seemed to be efficient in terms of the arbitrage argument, even after the financial crisis of 2008.