Covered interest arbitrage profits: The role of liquidity and credit risk

We study the profitability of Covered Interest Parity (CIP) arbitrage violations and their relationship with market liquidity and credit risk using a novel and unique dataset of tick-by-tick firm quotes for all financial instruments involved in the arbitrage strategy. The empirical analysis shows that positive CIP arbitrage deviations include a compensation for liquidity and credit risk. Once these risk premia are taken into account, small arbitrage profits only accrue to traders who are able to negotiate low trading costs. The results are robust to stale pricing and the nonsynchronous trading occurring in the markets involved in the arbitrage strategy.     

Price Expectation and the Pricing of Stock Index Futures

Capital markets are not perfect or frictionless, and arbitrage mechanism cannot be complete, particularly for index arbitrage. This study constructs a theoretical foundation to explain why the price expectation of the underlying asset should be entered into the pricing formula of stock index futures. The price expectation and incompleteness of arbitrage then are taken into account to develop a pricing model of stock index futures in imperfect markets. This study also presents three approaches for estimating the model parameter. Finally, the concept of the degree of market imperfection is defined and the valuation model is provided.     

Hysteresis bands on returns,holding period and transaction costs

In the presence of transactions costs, no matter how small, arbitrage activity does not necessarily render equal all riskless rates of return. When two such rates follow stochastic processes, it is not optimal immediately to arbitrage out any discrepancy that arises between them. The reason is that immediate arbitrage would induce a definite expenditure of transactions costs whereas, without arbitrage intervention, there exists some, perhaps sufficient, probability that these two interest rates will come back together without any costs having been incurred. Hence, one can surmise that at equilibrium the financial market will permit the coexistence of two riskless rates that are not equal to each other. For analogous reasons, randomly fluctuating expected rates of return on risky assets will be allowed to differ even after correction for risk, leading to important violations of the Capital Asset Pricing Model. The combination of randomness in expected rates of return and proportional transactions costs is a serious blow to existing frictionless pricing models.     

Stock index futures arbitrage in emerging markets: Polish evidence

The efficiency of the market for stock index futures and profitability of arbitrage for contracts on the Warsaw Stock Exchange Index WIG20 is studied in this paper. The Polish market has unique attributes: in a relatively short time the risk-free interest rate has decreased significantly, short sale cannot be used to construct an arbitrage position by institutional investors, and the dividends are small and paid in an irregular manner. Examining intraday transaction data shows that ex post and ex ante violations for short arbitrage reveal almost all properties of a mature market. Nonetheless, findings for long arbitrage indicate inefficiency of the market.     

Pricing Efficiency in a Thin Market with Competitive Market Makers: Box Spread Strategies in the Hang Seng Index Options Market

Using a box spread arbitrage strategy, we examine the pricing efficiency of the emerging, thinly traded Hang Seng Index options market in Hong Kong, where market makers operate under a competitive open outcry system. In 20 months of tick‐by‐tick bid‐ask and transaction quotes we find very few arbitrage opportunities. Our examination of the reporting time of quotes shows that in effect, all the apparent mispricings are deceptive and could be explained by stale quotes. The absence of real arbitrage opportunities supports the pricing rationality hypothesis in the Hong Kong options market.     

Convertible bond arbitrage,liquidity externalities,and stock prices

In the context of convertible bond issuance, we examine the impact of arbitrage activity on underlying equity markets. In particular, we use changes in equity short interest following convertible bond issuance to identify convertible bond arbitrage activity and analyze its impact on stock market liquidity and prices for the period 1993 to 2006. There is considerable evidence of arbitrage-induced short selling resulting from issuance. Moreover, we find strong evidence that this activity is systematically related to liquidity improvements in the stock. These results are robust to controlling for the potential endogeneity of arbitrage activity.     

Mispricing and lasting arbitrage between parallel markets in the Czech Republic

If co-existing parallel markets are efficient, then arbitrage will maintain a correct pricing relationship. A related question is whether two parallel emerging markets offering more or less the same securities but using different institutional designs, can behave as a single, fully integrated market. In this paper an explicit model of price convergence (with transaction costs) is introduced, in which price differences are studied using levels of arbitrage activity. For the empirical analysis two parallel markets in the Czech Republic are used — the Prague Stock Exchange (PSE) and the RMS (over-the-counter system). In particular, the degree of arbitrage activity is studied for different segments of the PSE and the evolution of arbitrage in the early history of these emerging markets. The empirical results provide evidence of market linkage for actively traded stocks. A significant relationship is found between the segment of the market to which a given firm belongs and the estimated level of arbitrage trading. Moreover, the level of arbitrage activity increases over time for all market segments, and as the markets mature, the differences among the segments gradually disappear.     

Index arbitrage and the pricing relationship between Australian stock index futures and their underlying shares

This paper examines the mispricing of Australian stock index futures. Exogenous and endogenous price volatility is confirmed to have a positive impact on the mispricing spread, after filtering out predictable time series components. More accurate pricing associated with surprise trading volume in the underlying stocks is consistent with arbitrageurs acting to narrow price disparities relative to the futures market. Ex‐ante interest rate volatility is the primary source of risk faced by arbitrageurs and fluctuations in the transaction cost of opening index arbitrage positions influence the extent to which they drive prices towards theoretical fair values.     

Efficiency in index options markets and trading in stock baskets

Researchers have reported mispricing in index options markets. This study further examines the efficiency of the S&P 500 index options market by testing theoretical pricing relationships implied by no-arbitrage conditions. The effect of a traded stock basket, Standard and Poor’s Depository Receipts (SPDRs), on the link between index and options markets is also examined. We find that pricing efficiency within option markets improves but there is little evidence to support the hypothesis that a stock basket enhances arbitrage across markets. When transactions costs and short sales constraints are included, very few violations of inter-market pricing relationships such as put–call parity are reported. However, violations of within market pricing relationships such as the box spread remain frequent. Extensive analysis suggests that the results are robust.     

存在市场摩擦条件下股指期货定价模型及其应用——以沪深300股指期货为例

依据无套利原理,考察存在市场摩擦条件下股指期货定价模型,并将其应用于我国股指期货市场,构建沪深300股指期货套利模型。该套利模型考虑了现实中存在的交易成本、借贷利差等市场摩擦因素对套利机会的影响,从而在实务中具有一定的参考价值。     

Futures Options and the Volatility of Futures Prices

Assuming nonstochastic interest rates, European futures options are shown to be European options written on a particular asset referred to as a futures bond. Consequently, standard option pricing results may be invoked and standard option pricing techniques may be employed in the case of European futures options. Additional arbitrage restrictions on American futures options are derived. The efficiency of a number of futures option markets is examined. Assuming that at-the-money American futures options are priced accurately by Black's European futures option pricing model, the relationship between market participants' ex ante assessment of futures price volatility and the term to maturity of the underlying futures contract is also investigated empirically.     

Equity market valuation of human capital and stock returns

We investigate whether and how well firms’ stock market valuations reflect their employees’ collective skills and effectiveness relative to that of their industry peers and competitors. We devise a relative stock market valuation measure of human capital intangibles (EVHC) and find that portfolios of low EVHC firms systematically outperform portfolios of high EVHC firms by an average 1.34% per month. However, this is primarily a small firms effect, because for large firms the excess returns of the arbitrage portfolio that is long on the low EVHC stocks and short on the high EVHC stocks is zero. Our results suggest that reliance on human capital intangibles may proxy for risk not fully accounted for by conventional asset pricing models, or alternatively, that the market cannot correctly price human capital intangibles for small size firms.     

Market transparency,liquidity externalities,and institutional trading costs in corporate bonds

We develop a simple model of the effect of public transaction reporting on trade execution costs and test it using a sample of institutional trades in corporate bonds, before and after initiation of the TRACE reporting system. Trade execution costs fell approximately 50% for bonds eligible for TRACE transaction reporting, and 20% for bonds not eligible for TRACE reporting, suggesting the presence of a “liquidity externality.” The key results are robust to changes in variables, such as interest rate volatility and trading activity that might also affect execution costs. Market shares and the cost advantage to large dealers decreased post-TRACE. These results indicate that market design can have first-order effects, even for sophisticated institutional customers.     

Pricing of national index funds

This article investigates the pricing behavior of national index funds (NIFs). Under barriers to capital flows in an otherwise perfect capital market, the familiar result of zero premium/discount obtains. The more realistic assumption of imperfect cross-border arbitrage suggests that in a two country setting the NIFs will sell at a premium. In a multicountry framework, the investment barriers will result in NIFs generally trading at a premium, although theoretically one cannot rule out a discount from net asset value (NAV). A simple test supports the proposition that under investment barriers, NIFs should trade at a premium to NAV after controlling for the average domestic closed-end fund discount.     

Option Pricing and Replication with Transactions Costs

Transactions costs invalidate the Black-Scholes arbitrage argument for option pricing, since continuous revision implies infinite trading. Discrete revision using Black-Scholes deltas generates errors which are correlated with the market, and do not approach zero with more frequent revision when transactions costs are included. This paper develops a modified option replicating strategy which depends on the size of transactions costs and the frequency of revision. Hedging errors are uncorrelated with the market and approach zero with more frequent revision. The technique permits calculation of the transactions costs of option replication and provides bounds on option prices.     

Arbitrage with hedging by forward contracts: exploited and exploitable profits

The theoretical conditions for covered interest arbitrage and exploitable profit opportunities out of simple and triangular arbitrage in the absence and presence of market imperfection are enunciated. A distinction is made between pure arbitrage profits and arbitrage-induced total profits attainable under the risk-free environment. Operational feasibility of iterative arbitrage is also examined.     

Beyond segmentation: The case of China’s repo markets

This paper explores the reasons behind the discrepancy between interest rates in China’s two repurchase agreement (repo) markets, the interbank repo market and the exchange-traded repo market. The repo rates in the exchange market are at times, significantly higher than those in the interbank market, especially in the first three years of the 2000–2005 sample period. While market segmentation clearly hinders arbitrage, the causes of the repo rate discrepancy are related to the alternative investment opportunities available to market participants and to the volatility differences in the repo rates.     

The Current State of the Arbitrage Pricing Theory

This paper provides a simple proof of a recent theorem presented by Reisman (1992) , concerning the use of proxies for the factors in the return-generating process of the arbitrage pricing theory (APT). In the single-factor case, the theorem asserts that any variable correlated with the factor can serve as the benchmark in an approximate APT expected return relation. The significance of this result is considered and a new direction for empirical work on “arbitrage pricing” is outlined.     

Measuring the pricing error of the arbitrage pricing theory

This article provides an exact Bayesian framework for analyzingthe arbitrage pricing theory (APT). Based on the Gibbs sampler,we show how to obtain the exact posterior distributions forfunctions of interest in the factor model. In particular, wepropose a measure of the APT pricing deviations and obtain itsexact posterior distribution. Using monthly portfolio returnsgrouped by industry and market capitalization, we find thatthere is little improvement in reducing the pricing errors byincluding more factors beyond the first one.     

Hedging index exchange traded funds

This paper presents an empirical comparison of the out of sample hedging performance from naïve and minimum variance hedge ratios for the four largest US index exchange traded funds (ETFs). Efficient hedging is important to offset long and short positions on market maker’s accounts, particularly imbalances in net creation or redemption demands around the time of dividend payments. Our evaluation of out of sample hedging performance includes aversion to negative skewness and excess kurtosis. The results should be of interest to hedge funds employing tax arbitrage or leveraged long–short equity strategies as well as to ETF market makers.