Arbitrage and Viability in Insurance Markets

Insurance markets are subject to transaction costs and constraints on portfolio holdings. Therefore, unlike the frictionless asset markets case, viability is not equivalent to absence of arbitrage possibilities. We use the concept of unbounded arbitrage to characterize viable prices on a complete and an incomplete insurance market. In the complete market, there is an insurance contract for every possible event. In the incomplete market, risk can be insured through proportional and excess of loss like insurance contracts. We show how the the structure of viable prices is affected by the portfolio constraints, the transaction costs, and the structure of marketed contracts.     

Intra-Day Arbitrage Opportunities in Foreign Exchange and Eurocurrency Markets

We have two primary objectives in this study. First, we examine the frequency of attaining simultaneous equilibrium on spot and forward foreign exchange markets and on domestic and foreign securities markets. Second, we measure the profitability of covered interest arbitrage and one-way arbitrage. Our empirical analysis has been conducted using real-time quotations. The empirical results indicate that: (a) the markets are efficient in the sense that profit opportunities from traditional covered interest arbitrage are rarely available; and (b) the frequency of attaining simultaneous market equilibrium is surprisingly low, thus opening the door for one-way arbitrage.     

Unchecked manipulations,price–volume relationship and market efficiency: Evidence from emerging markets

This paper investigates how unchecked manipulations could cause frequent trade-induced manipulations and weak-form market inefficiency in South Asian stock markets [Bombay Stock Exchange (BSE), Dhaka Stock Exchange (DSE) and Karachi Stock Exchange (KSE)]. Specifically, the paper analyses the price–volume relationship as one of the many cases of market inefficiency. By employing various econometric tests, this paper first provides conclusive evidence of market inefficiency in these markets. It then extracts evidence of manipulation periods from legal cases and analyses price–volume relationship during these periods. The paper finds that there exists market-wide trading-induced manipulations, where excessive buying and selling causes prices to inflate artificially before crashing down. The paper concludes that South-Asian markets are inefficient in the weak-form.     

Limited arbitrage between equity and credit markets

We document that short-horizon pricing discrepancies across firms' equity and credit markets are common and that an economically significant proportion of these are anomalous, indicating a lack of integration between the two markets. Proposing a statistical measure of market integration, we investigate whether equity–credit market integration is related to impediments to arbitrage. We find that time variation in integration across a firm's equity and credit markets is related to firm-specific impediments to arbitrage such as liquidity in equity and credit markets and idiosyncratic risk. Our evidence provides a potential resolution to the puzzle of why Merton model hedge ratios match empirically observed stock-bond elasticities (Schaefer and Strebulaev, 2008) and yet the model is limited in its ability to explain the integration between equity and credit markets (Collin-Dufresne, Goldstein, and Martin, 2001).     

Stock Market Valuation,Foreign Investment,and Cross-Country Arbitrage

This study investigates the role of stock market valuation and cross-country arbitrage in shaping foreign direct and indirect investments, contingent upon a country's stage of development. This paper is built upon the mispricing-driven foreign investment hypotheses developed by Baker, Foley, and Wurgler (2009). Interesting findings emerge when developed and emerging markets are considered separately. Empirical evidence indicates that the use of relatively cheap financial capital for foreign investment is prominent among developed countries, but not so in emerging markets. This is largely due to the extremely low level of foreign investment outflows in emerging markets and the inability of unsophisticated emerging market managers to successfully time the market. Further investigation shows that host-country stock market valuation is an important determinant of the mode of foreign investment; investors tend to choose indirect or portfolio investment, as opposed to direct investment, when the stock market is perceived to be undervalued. This is especially the case in emerging markets, where there is more room for misvaluation and potential arbitrage. These findings suggest that the unique institutional features of the markets involved play an important role in shaping foreign investment and cross-country arbitrage.     

Characteristics of Risk and Return in Risk Arbitrage

This paper analyzes 4,750 mergers from 1963 to 1998 to characterize the risk and return in risk arbitrage. Results indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in flat and appreciating markets. This suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Using a contingent claims analysis that controls for the nonlinear relationship with market returns, and after controlling for transaction costs, we find that risk arbitrage generates excess returns of four percent per year.     

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.     

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.     

The effect of liquidity and arbitrage on the price efficiency of Chinese ETFs

We study the potential factors that determine the large and persistent price deviations in Chinese equity exchange-traded funds (ETFs). Our results suggest that ETF liquidity and arbitrage activity are positively correlated with ETF price efficiency, and the relation is more pronounced with higher institutional ownership. We also evaluate the effect of two exogenous shocks in the Chinese market. Using a policy change that added market makers to ETFs on the Shenzhen Stock Exchange (SZSE) and Shanghai Stock Exchange (SSE), we find that market makers improve price efficiency and that the impact is stronger for ETFs with lower liquidity. We also exploit a change in trading rules on the SZSE and show that the relaxation of arbitrage restrictions improves price efficiency. Altogether, these findings provide evidence that lack of liquidity, due to the unique market structure and regulations of the Chinese market, contributes to price inefficiency of Chinese ETFs.     

On a class of diverse market models

A market model in Stochastic Portfolio Theory is a finite system of strictly positive stochastic processes. Each process represents the capitalization of a certain stock. If at any time no stock dominates almost the entire market, which means that its share of total market capitalization is not very close to one, then the market is called diverse. There are several ways to outperform diverse markets and get an arbitrage opportunity, and this makes these markets interesting. A feature of real-world markets is that stocks with smaller capitalizations have larger drift coefficients. Some models, like the volatility-stabilized model, try to capture this property, but they are not diverse. In an attempt to combine this feature with diversity, we construct a new class of market models. We find simple, easy-to-test sufficient conditions for them to be diverse and other sufficient conditions for them not to be diverse.     

The Behavior of an Institutional Investor with Arbitrage Opportunities and Liquidity Risk

This study analyzes the efficiency of liquidity flows in stabilizing distressed markets from a theoretical perspective. We show that even in the event of a major negative market shock, a financial institution can increase its investment in the market when there is a strong incentive for arbitrage profit. However, the institution may choose to reduce its investment if the fear from liquidity risk exceeds the arbitrage incentive. In addition, our model reveals a positive relationship between funding liquidity and market liquidity. Our findings help to explain several financial issues in distressed markets, including the flight to quality, liquidity dry-ups, asset fire sales, and market shock amplifications.     

Large traders,hidden arbitrage,and complete markets

This paper studies hidden arbitrage opportunities in markets where large traders affect the price process, and where the market is complete (in the classical sense). The arbitrage opportunities are “hidden” because they occur on a small set of times (typically of Lebesgue measure zero). These arbitrage opportunities occur naturally in markets where a large trader supports the price of some asset or commodity, for example corporate stock repurchase plans, government interest rate or foreign currency intervention, and price support by investment banks in IPOs. We also illustrate immediate arbitrage opportunities generated by usual market activity at specific points in time, for example the issuance date of an IPO or the inclusion date of a new stock in the S&P 500 index.     

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.     

Short Selling and Index Arbitrage Profitability: Evidence from the SGX MSCI and TAIFEX Taiwan Index Futures Markets

There are numerous impediments to market efficiency and index arbitrage in real capital markets, including the uptick rule on short selling, execution risk, market impact costs, regulatory barriers, and capital constraints. Adopting and relaxing the uptick restriction in the Taiwan stock market facilitated a study on whether adjustments in this restriction influence the efficiency and arbitrage of the Singapore Exchange Limited (SGX) and the Taiwan Futures Exchange (TAIFEX) index futures markets. This study examines the above issues using five-minute intraday transaction data and performs an ex post test of arbitrage, ex ante test of arbitrage, and regression analysis. Empirical results indicate that relaxing the uptick rule should improve market efficiency and facilitate long arbitrage, subsequently accelerating the adjustment to no-arbitrage bounds and helping to decrease ex post and ex ante mispricing and underpricing following the relaxation.     

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.     

Options Arbitrage in Imperfect Markets

Option valuation models are based on an arbitrage strategy—hedging the option against the underlying asset and rebalancing continuously until expiration—that is only possible in a frictionless market. This paper simulates the impact of market imperfections and other problems with the “standard” arbitrage trade, including uncertain volatility, transactions costs, indivisibilities, and rebalancing only at discrete intervals. We find that, in an actual market such as that for stock index options, the standard arbitrage is exposed to such large risk and transactions costs that it can only establish very wide bounds on equilibrium options prices. This has important implications for price determination in options markets, as well as for testing of valuation models.     

Measuring Pricing Inefficiencies Under Stressful Market Conditions

This study examines the mispricing and time between arbitrage trades of the Hong Kong Hang Seng index futures and index options contracts under various stressed market conditions. Ex‐ante trading profits and differences in time between trades across up and down as well as stressed and non‐stressed markets are used to measure how well the derivative markets perform under emotional distress. We find evidence of illiquidity in stressed and down markets. In stressful markets and down markets, liquidity suppliers are less likely to trade against the informed traders. This, in turn, leads to longer time between trades and higher arbitrage profits.     

Price discovery and persistent arbitrage violations in credit markets

This paper investigates price violations in credit markets using a data sample spanning from 2002 to 2016. We find that price violations are highly persistent during the crisis period, particularly for speculative-grade bonds. There is evidence that price distortions and market disintegration are linked to market-wide and firm-level impediments to arbitrage and limited capital provision. Higher firm-level impediments to arbitrage lead to less market integration, and more severe and persistent pricing discrepancies. Moreover, we find that the negative CDS basis persists in the postcrisis period, which is attributable to dealers’ lower capital commitment and deterioration in market-making quality.     

Has financial market integration increased during the nineties?

This paper analyses whether there has been an increase in the degree of financial market integration during the nineties. To do this, we focus on stock markets and compute two alternative measures of market integration based on a refinement of the approach suggested by Chen, Z., Knez, P.J., 1995. [Measurement of market integration and arbitrage, Review of Financial Studies 8(2), 287–325]. The main advantage of this approach is that it relies on the condition of absence of arbitrage opportunities, which is directly related to the idea that more integration means less barriers to trade across markets — and does not depend on any particular asset pricing model. The evidence found suggests that during the nineties there has been an increase of the degree of market integration between stock markets.     

Long-run dynamics of official and black-market exchange rates in Latin America

This paper attempts to investigate the long-run dynamic relationship between official and black-market exchange rates for four Latin America markets namely, Argentina, Brazil, Chile, and Mexico. We follow (Moore, M. J., & Phylaktis, K. (2000). Black and official exchange rates in the Pacific Basin: Some tests of dynamic behaviour. Applied Financial Economics, 10, 361–369.) and we distinguish between long-run informational efficiency and short-run predictability in a sense that these notions are compatible with cointegration and error-correction mechanisms (ECM). Our findings indicate a constant black-market premium for each country, which is taken as strong support for long-run informational efficiency between the official and black markets for foreign currency. In addition, the evidence of short-run predictability is not considered as a violation of market efficiency, but it is the outcome of optimal arbitrage by rational economic agents.