Comment on The Saga of the First Stock Index Futures Contract: Was It a Case of the Market Using the Wrong Model and Not Learning?

This is a useful paper, giving an historical example of a market that seems to have been efficiently wrong.

I don't want to spend much time critiquing details of the methodology of this demonstration. The only question I would raise in that regard is whether there might be a more rigorous—or at least less subjective—technique for dating breaks in the time series of mispricing futures prices. For example, one of my colleagues, John Carlson, has been using breakpoint analysis for dating shifts in the time series of the velocity of money. I should think this technique could be applied equally successfully to the options mispricing time series.

I do want to spend some time raising a few questions that the paper doesn't investigate, but that should be worth exploring.

The first of these questions is about the relation between the model that arbitrageurs might have used to guide their market actions and the profits from arbitrage. Sam points out that the conventional market wisdom apparently did not recognize that the appropriate model for pricing KCVL geometric futures was not the same as the model appropriate to most other futures contracts. This appears to be confirmed by the time series of mispricing, which shows persistent mispricing lasting about four years after the six-month shakedown period of the new contract. Two puzzles spring from this episode of mispricing. One is the temporal association between the time at which mispricing ceased and the publication in the Journal of Finance of the "correct" model for pricing KCVL geometric futures. Was it the academic event of publication that caused the real world event of shifting from incorrect to correct pricing? Second, as Sam points out, why would the correct model have to be published in the Journal of Finance, or anywhere at all, for arbitrageurs to have discovered that they were using the wrong model? That is, why didn't the persistent experience of mispricing cause market participants to revise their priors about the correct range of prices even without an academic demonstration of how to define that range? Why didn't experience teach the lesson by induction rather than waiting to be taught by deduction?

I have to confess to some skepticism about the suggested connection between the move to correct pricing and the publication of the Eytan-Harpaz model. I'm not sure how much stock to put in the matter of timing. Apparently, Volume 41, #4—the September issue—of the Journal of Finance was in the hands of subscribers in the second week of September 1986. I reach that conclusion on the basis of a sample of one subscriber. The Research Library of the Federal Reserve Bank of Cleveland time-stamps incoming items upon arrival. The copy in the Library stacks is time stamped 11:36 A.M. September 8, 1986. That was just three weeks before the end of the third quarter. Sam's Figure 2 and accompanying text seem pretty clear that mispricing ended about two months before the appearance of the September issue of the Journal of Finance.

Now, of course, we all know that journal articles don't spring full-blown from the fingertips of their joint authors on the day a journal is received, or even the day it is printed. It would be helpful to know more about the prepublication history of the article. Who were the referees? When did they see the draft? Did they subsequently become wealthy? Also, might there be a relation between the rather precipitous decline in KCVL trading volume starting eight months earlier, in January 1986, and the prepublication circulation of the truth-telling article? Or might that precipitous decline in trading volume simply reflect the accumulation of bad experience by those who had been trading efficiently with the wrong model in their heads, and therefore gave up trading the contract altogether?

How long might it take a market to equilibrate at the correct price? Is slightly less than four years a reasonable real...