dividend yield on stocks and be guaranteed a return on his or her stocks
that is the difference between the futures price and the current price.
Since both these investments deliver a guaranteed, riskless sum,
they must earn the same rate of return. That means that the futures price
for stocks must be sufficiently above the current price to compensate the
investor for the difference between the yield on stocks and the yield on
bonds. In other words, the futures price must be above the current price
(in percentage terms) by i–d, the interest rate minus the dividend yield.^8
DOUBLE AND TRIPLE WITCHING
Index futures play some strange games with stock prices on the days
when futures contracts expire. Recall that index arbitrage works through
the simultaneous buying or selling of stocks against futures contracts.
On the day that contracts expire, arbitrageurs unwind their stock posi-
tions at precisely the same time that the futures contracts expire.
Index futures contracts expire on the third Friday of the last month
of each quarter: in March, June, September, and December. Index op-
tions and options on individual stocks, which are described later in the
chapter, settle on the third Friday of every month. Hence four times a
year, all three types of contracts expire at once. This expiration has in the
past produced violent price movements in the market, and it is conse-
quently termed a triple witching hour. The third Friday of a month when
there are no futures contract settlements is called a double witching, and it
displays less volatility than triple witching.
There is no mystery why the market is volatile during double or
triple witching dates. On these days, the specialists on the New York
Stock Exchange and the market makers on the Nasdaq are instructed to
buy or sell large blocks of stock on the close, whatever the price, because
institutional investors are closing out their arbitrage positions. If there is
a huge imbalance of buy orders, prices will soar; if sell orders predomi-
nate, prices will plunge. These swings, however, do not matter to arbi-
trageurs since the profit on the future position will offset losses on the
stock position, and vice versa.
In 1988, the New York Stock Exchange urged the Chicago Mercan-
tile Exchange to change its procedures and stop futures trading at the
close of Thursday’s trading and settle the contracts at Friday opening
prices rather than at Friday closing prices. This change gave specialists
260 PART 4 Stock Fluctuations in the Short Run
(^8) If the dividend yield is more than the interest rate, then the futures price will be below the current
price.