Search Results
Journal Article
Asset mispricing, arbitrage, and volatility
Market efficiency remains a contentious topic among financial economists. The theoretical case for efficient markets rests on the notion of risk-free, cost-free arbitrage. In real markets, however, arbitrage is not risk-free or cost-free. In addition, the number of informed arbitrageurs and the supply of financial resources they have to invest in arbitrage strategies is limited. This article builds on an important recent model of arbitrage by professional traders who need?but lack?wealth of their own to trade. Professional abitrageurs must convince wealthy but uninformed investors to entrust ...
Journal Article
Fact and fantasy about stock index futures program trading
Working Paper
An international arbitrage pricing model with PPP deviations
This paper develops an intertemporal, international asset pricing model for use in applied theoretical and empirical research. An important feature of the model is that it incorporates both stochastic inflation rates and stochastic Purchasing Power Parity deviations (PPP). The model derives the equilibrium real return on assets, and obtains empirically tractable reduced form equations which can be used to examine such issues as capital market segmentation, currency substitution, exchange rate volatility, and the forward exchange market's risk premium. Mechanically, the model begins as a ...
Working Paper
Exchange-rate puzzles in a model with arbitrage.
This paper documents the implications of arbitrage costs on the behavior of exchange rates in an open-economy liquidity model. The main motivation behind the paper is the growing evidence that the well-documented departures from purchasing power parity are due to a failure of the law of one price. The paper quantifies the importance of arbitrage costs for the variability, persistence, and autocorrelation of real and nominal exchange rates and compares the results with those of a model with nominal rigidities and firms pricing to market; second, the paper studies the impact of currency risk ...
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Inference, arbitrage, and asset price volatility
This paper models the impact of arbitrageurs on stock prices when arbitrageurs are uncertain about the drift of the dividend process of a risky asset. Under perfect information, the presence of risk-neutral arbitrageurs unambiguously reduces the volatility of asset returns. When arbitrageurs are uncertain about the drift of the dividend process, they condition their investment strategy on the observation of dividends and trading volume. In such a setting, the presence of arbitrageurs can lead to an increase in the equilibrium volatility of asset returns. The arbitrageurs' inference problem ...
Working Paper
Direct tests of index arbitrage models
Previous tests of stock index arbitrage models have rejected the no-arbitrage constraint imposed by these models. This paper provides a detailed analysis of actual S&P 500 arbitrage trades and directly relates these trades to the predictions of index arbitrage models. An analysis of arbitrage trades suggests that (i) short sale rules are unlikely to restrict arbitrage, (ii) the opportunity cost of arbitrage funds exceeds the Treasury Bill rate, and (iii) the average price discrepancy captured by arbitrage trades is small. Tests of the models provide some support for a version of the arbitrage ...
Journal Article
Trading risk, market liquidity, and convergence trading in the interest rate swap spread
While trading activity is generally thought to play a central role in the self-stabilizing behavior of markets, the risks in trading on occasion can affect market liquidity and heighten asset price volatility. This article examines empirical evidence on the limits of arbitrage in the interest rate swap market. The author finds both stabilizing and destabilizing forces attributable to leveraged trading activity. Although the swap spread tends to converge to its fundamental level, it does so more slowly or even diverges from its fundamental level when traders are under stress, as indicated by ...
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Measuring the pricing error of the arbitrage pricing theory
This paper provides an exact Bayesian framework for analyzing the arbitrage pricing theory (APT). Based on the Gibbs sampler, we show how to obtain the exact posterior distributions for functions of interest in the factor model. In particular, we propose a measure of the APT pricing deviations and obtain its exact posterior distribution. Using monthly portfolio returns grouped by industry and market capitalization, we find that there is little improvement in reducing the pricing errors by including more factors beyond the first one.