Financially Constrained Index Futures Arbitrage

We develop two models for index futures arbitrage that take the financing constraints faced by real-world arbitrageurs into account. Our models predict that the price of an index futures contract and the value of its underlying index should deviate further from their theoretical cost-of-carry relationship when (a) the contract has a longtime to go before expiry, and (b) volatility is high. The fact that these predictions enjoy considerable empirical support highlights the importance of financing constraints for explaining index futures mispricing.