A Threshold Error Correction Model for Intraday Futures and Index Returns

Index-futures arbitragers only enter into the market if the deviation from the arbitrage relation is large enough to compensate for transaction costs and associated interest rate and dividend risks. We estimate the band around the theoretical futures price within which arbitrage is not profitable for most arbitragers, using a threshold autoregression model. Combining these thresholds with an error correction model, we can make a distinction between the effects of arbitragers and infrequent trading on index and futures returns.