Informed Trading, Short Sales Constraints and Futures' Pricing.

The purpose of this paper is to provide an explanation for relative pricing of futures contracts with respect to underlying stocks using a model incorporating short sales constraints and informational lags between the two markets. In this model stocks and futures are perfect substitutes, except for the fact that short sales are only allowed in futures markets. The futures price is more informative than the stock price, because the existence of short sales constraints in the stock market prohibits trading in some states of the world. If an informed trader with no initial endowment in stocks receives negative information about the common future value of stocks and futures, he is only able to sell futures. Uninformed traders also face a similar short sales constraint in the stock market. As a result of the short sales constraint, the stock price is less informative than the futures price even if the informed trader has received positive information.