When transaction costs are considered, it can be seen that the relationship between a futures contract and its underlying stock index is defined, not by a “fair price,” but by a “fair range” of prices that lie in a window about the value of the underlying index. Opportunities to arbitrage profitably between the cash and futures markets (by either buying futures or selling them short) will occur only when futures prices lie outside this fair range, or window. In other words, any prices within the window are fair.

Defining the fair futures value as a range, rather than a point, has implications for some common assumptions about futures markets. Although it is commonly accepted that futures markets are more cost-effective than the physical stocks for creating or reducing market exposure, this is not always the case. Futures may be sufficiently costly (even at fair prices) that direct transactions in the underlying stock would be more opportune.

Similarly, futures are commonly held responsible for observed increases in stock market volatility. The argument is that futures markets provide a ready outlet for negative (or positive) market sentiment, which is then transmitted to equity markets. But in very strong and very weak markets, futures are likely to be priced at the boundaries of the arbitrage window, so that it would be more profitable to trade in stocks. Portfolio insurance programs can lead to an increase in the frequency of market adjustments (via compression volatility); this effect, however, should not be viewed as a threat to either futures or equity market efficiency.