Tick size signifies the minimum stock price increment unit. Reduction of tick size is crucial for the government officials since it might affect market liquidity, and consequently the entire functioning of financial markets. If the price movement determined by investors turns out to be smaller than the minimum stock price increment unit settled by the stock exchange, the price movement will turn larger to the tick size restriction. As a result, the spread which constitutes a major part of investors’ trading cost between best bid and ask prices will ascend. Because the larger transaction cost impedes the investors to trade and trigger arbitrage, mispricing error (MPE) between futures and spot would become larger, meaning worse pricing efficiency. Advocates of the adoption of reduction argue that the better formation of stock prices will benefit investors. Because the restriction of pricing increment dominates the possible minimum bid-ask spread for every stock. This spread means the difference between the lowest price an investor can get for selling the stock and the highest price an investor can pay for purchasing the same stock.
On the other hand, reduction of tick size may affect not only bid-ask spread.
Harris (1994, 1997) and Furfine (2003) argue that a smaller tick size can inhibit incentives to provide liquidity, and potentially ruin market quality. For large traders, quoted depth at the best-quoted prices may be insufficient to fill the desired order.
In consequence, the effective transaction price lies somewhere outside the best bid and ask prices. These costs originate from the lack of supply and demand shares that can be purchased and sold at the same price. In general, these studies find that the smaller tick size decreases quoted and effective bid-ask spread, but also reduces liquidity provision.
For the purpose of studying the evidently contradictory findings reported in previous papers, many studies use different estimators to examine whether and/or to
what extent market liquidity was affected by decimalization. Most of them eventually find that decimalization do improve the decrease of overall transaction cost (Harris, 1997; Bollen and Whaley, 1998; Chakravarty, Van Ness, and Van Ness, 2005;
Furfine, 2003; Bessembinder, 2003; Chakravarty, Panchapagesan, and Wood, 2003).
Taiwanese financial authorities enforce a succession of revolution in an endeavor to abate the trading restriction, liberalize financial market, attract more investors to enter into the market as well as connect to the international financial market further. On March 1, 2005, the Taiwan Stock Exchange (TSE) reduced the minimum change for stock prices and quotes to lower the trading costs of investors and to promote stock price continuity. Investors can memorize the new tick size and price interval combination much easier and have more tick to quote and trade according to their trading strategies.
This paper examines the effect of the decrease in transaction cost resulted from the shrink of tick size on Taiwan Stock Exchange Capitalization Weighted Stock Index (TAIEX) futures pricing efficiency. Lower transaction cost is supposed to bring about a decline in the index futures mispricing error (MPE) that triggers arbitrage. However, this supposition may be erroneous because of the following reasons. First, Goldstein and Kavajecz (2000) and Jones and Lipson (2001) discover that transaction costs decrease only for small orders because cumulative market depth falls after the reduction of tick size. Second, Neal (1996) finds that arbitrageurs earn on average only around half the quoted spread for each round-trip arbitrage trade.
Therefore, arbitrageurs must be able to trade at prices inside the quoted spread for arbitrage to be profitable. With above considerations in mind, we identify and investigate two important empirical questions. First, does the reduction of the minimum price increment affect the level of the arbitrage costs, and second, has pricing efficiency improved in the new milieu.
Nevertheless, the volatility of spot and futures affects the arbitrage behavior heavily. Higher volatility leads to an increase in timing risk and in tracking error risk incurred from trading only a subset of the stocks underlying the index.
Increased volatility of the futures and the underlying market will enhance the execution risk for the position. In periods of high volatility, one would expect arbitrageurs to initiate trades only at relatively higher MPEs to make up for the increased price risk of nonsimultaneous order execution (Henker, Thomas and Martin Martens (2005)). The MPEs may be affected not only by the transaction cost but also by spot and futures volatility. With the above consideration, this study will carry out the following examinations. First, do the volatility of the spot and futures market significantly alter across the pre- and post-reduction period, and second, if the volatility of futures and spot significantly alter across two sample periods, has pricing efficiency improved in the new milieu after controlling for the volatility effect.
The existence of transaction costs and other market imperfection factors might cause the error correction effects on the price adjustment be significant only when the deviation of price between futures and spot is larger than a certain threshold.
Martens, Kofman and Vorst (1998) find strong evidence of nonlinear adjustment in the presence of transactions. Dwyer, Locke, and Yu (1996) discover that a threshold error correction mechanism could characterize nonlinear dynamic relationship between the S&P500 futures and spot more properly. Reduction of tick size would affect transaction costs heavily; therefore, we will further investigate the impact of the reduction of tick size on nonlinear dynamic relationship between TAIEX index futures and spot.
Most of the previous studies focus the effect of tick size changes on the liquidity, volatility, market depth of the stock markets. However, fewer studies investigated the impact of the reduction of tick size on index futures pricing efficiency, arbitrage
behavior and nonlinear dynamic relationship. The theoretical price of index futures is derived from the spot index; therefore, spot index behavior is highly related with futures pricing efficiency. Hence, this paper will examine the pricing efficiency, arbitrage opportunities and nonlinear dynamic relationship between index futures and spot in the intraday level before and after the reduction of tick size.
The remainder of this paper is structured as follows. Section 2 discusses the tick size change on the stock exchanges. Section 3 is the literature review. Data and methodology are presented in Section 4, followed, in Section 5, by a discussion of the empirical results. Section 6 summarizes and concludes this paper.