ABSTRACT
The theory of arbitrage pricing contains a number of predictions about market behaviour. These include predictions that the no-arbitrage condition should generally apply, and when it ceases to apply this should promptly trigger index arbitrage transactions which rapidly eliminate the deviation from the no-arbitrage condition. The chapter provides a review of the empirical evidence on the degree to which actual futures prices deviate from the theoretical prices given by the no-arbitrage condition. It discusses the available evidence on the speed and size of the arbitrage response to a violation of the no-arbitrage condition. The chapter considers the link between mispricings and spot volatility and discusses some of the practicalities of arbitrage. Some studies of US index futures have found a predominance of underpricings; while others have found a predominance of overpricings. A number of studies have examined the properties of mispricings over time. It has been universally found that the number and magnitude of mispricings declines as delivery approaches.
