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When a stock is added into the S&P 500 Index, it in effect becomes cross-listed in the Index derivative markets. When index-based trading strategies such as index arbitrage are executed, the component stocks are directly affected by such trading. We find increased volatility of daily returns, plus increased trading volume for the underlying stocks. Utilizing a list of S&P 500 Index composition changes over the period September 1976 to December 2005, we study the market-adjusted volume turnover and return variance of the stocks added to and deleted from the Index. The results indicate that after the introduction of the S&P 500 Index futures and options contracts, stocks added to the S&P 500 experience statistically significant increase in both trading volume and return volatility. Both daily and monthly return variances increase following index inclusion. When stocks are removed from the index, though, neither volatility of returns nor trading volume experiences any significant change. So, we have new evidence showing that Index inclusion changes a firm's return volatility, and supporting the destabilization hypothesis.

I survey applications of Markov switching models to the asset pricing and portfolio choice literatures. In particular, I discuss the potential that Markov switching models have to fit financial time series and at the same time provide powerful tools to test hypotheses formulated in the light of financial theories, and to generate positive economic value, as measured by risk-adjusted performances, in dynamic asset allocation applications. The chapter also reviews the role of Markov switching dynamics in modern asset pricing models in which the no-arbitrage principle is used to characterize the properties of the fundamental pricing measure in the presence of regimes.

In this chapter, we define the “inflation forward rates” based on arbitrage arguments and develop a dynamic model for the term structure of inflation forward rates. This new model can serve as a framework for specific no-arbitrage models, including the popular practitioners’ market model and all models based on “foreign currency analogy.” With our rebuilt market model, we can price inflation caplets, floorlets, and swaptions with the Black formula for displaced-diffusion processes, and thus can quote these derivatives using “implied Black's volatilities.” The rebuilt market model also serves as a proper platform for developing models to manage volatility smile risks.

Through this chapter, we hope to correct two major flaws in existing models or with the current practices. First, a consumer price index has no volatility, so models based on the diffusion of the index are essentially wrong. Second, the differentiation of models based on zero-coupon inflation-indexed swaps and models based on year-on-year inflation-indexed swaps is unnecessary, and the use of “convexity adjustment,” a common practice to bridge models that are based on the two kinds of swaps, is redundant.

We examine the impact of the unique Japanese stock market microstructure on the pricing of stock index futures contracts. We use intraday transactions data for the Nikkei 225 Futures contracts in Osaka and the corresponding Nikkei 225 Index in Tokyo. Incorporating more realistic transaction-cost estimates and various institutional impediments in Japan, we find that the time-varying liquidity of some component shares of the index in Tokyo represents the most critical impediment to intraday arbitrage and often causes futures prices in Osaka to deviate significantly and persistently from their no-arbitrage boundary, especially for longer-lived contracts.

We show that if a lead-lag relation exists between the option and spot markets, the implied volatility in option prices can be biased depending on the level of the true volatility; that is, the higher the true volatility, the more upward biased the implied volatility will be. We then test the theoretical conjecture, using intraday transactions data of the S&P 500 stock index and its options. The empirical results show that the S&P 500 index option market leads the cash index, and that the bias of the implied volatility due to the lead-lag relation is statistically significant, confirming our theoretical conjecture.

The KOSPI 200 options at its initial stage generated a significant number of violations in no-arbitrage conditions which involve both options and the underlying index. However, when the arbitrage conditions are formed independent of the underlying index, the average size of violation is not large and few arbitrage opportunities exist. There are more frequent violations on near-maturity days, with in-the-money options and larger violation sizes during opening and closing hours. The arbitrage opportunities remain intact even after realistic transaction costs are taken into account and index futures prices are used instead of the stock index in an alternative specification.