Index arbitrage and nonlinear dynamics between the S&P 500 futures and cash
We use a cost of carry model with nonzero transactions costs to motivate estimation of a nonlinear dynamic relationship between the S&P 500 futures and cash indexes. Discontinuous arbitrage suggests that a threshold error correction mechanism may characterize many aspects of the relationship between the futures and cash indexes. We use minute-by-minute data on the S&P 500 futures and cash indexes. The results indicate that nonlinear dynamics are important and related to arbitrage and suggest that arbitrage is associated with more rapid convergence of the basis to the cost of carry than would be indicated by a linear model.
AUTHORS: Dwyer, Gerald P.; Locke, Peter; Yu, Wei
Deliverability and regional pricing in U.S. natural gas markets
During the 1980s and early '90s, interstate natural gas markets in the United States made a transition away from the regulation that characterized the previous three decades. With abundant supplies and plentiful pipeline capacity, a new order emerged in which freer markets and arbitrage closely linked natural gas price movements throughout the country. After the mid-1990s, however, U.S. natural gas markets tightened and some pipelines were pushed to capacity. We look for the pricing effects of limited arbitrage through causality testing between prices at nodes on the U.S. natural gas transportation system and interchange prices at regional nodes on North American electricity grids. Our tests do reveal limited arbitrage, which is indicative of bottlenecks in the U.S. natural gas pipeline system.
AUTHORS: Brown, Stephen P. A.; Yucel, Mine K.
Arbitrage: the key to pricing options
Arbitrage has become associated in popular attitudes with the most ruthless and profit-driven of human impulses, but the opposite reputation might be more well-deserved. The ability to arbitrage is essential for the efficient operation of markets. An interesting application of the principle of arbitrage arose when it provided the breakthrough insight in economists? solution to a formerly intractable problem: how to properly price the emergent financial instruments known as options.
AUTHORS: Nosal, Ed; Wang, Tan
Decentralized credit markets with intermediaries: a relationship between complete and efficient markets
AUTHORS: Benveniste, Lawrence M.
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 system of stochastic differential equations which describe the dynamic paths of a vector of state variables, prices, and PPP deviations. The state variables' intertemporal development determines the production and credit opportunities, and provides the model's fundamental dynamic nature. The model is shown to be consistent with the domestic-general equilibrium asset pricing models of Cox, Ingersoll, and Ross (1985) and Brock (1982). The model is applied to pricing forward exchange, and an empirically tractable equation of the risk premium is derived which will allow researchers to uncover the risk premium's economic determinants.
AUTHORS: Levine, Ross
Macroeconomic risk and asset pricing: estimating the apt with observable factors
This paper develops and applies a new maximum likelihood method for estimating the Arbitrage Pricing Theory (APT) model with observable risk factors. The approach involves simultaneous estimation of the factor loadings and risk premiums and can be applied to return panel with more securities than time series observations per security. Observable economic factors are found to account for 25 to 40 percent of the covariation in U.S. equity returns, and the APT pricing restrictions cannot be rejected for most sample periods. A significant "firm size anomaly" is measured, but it may be partly due to sample selection bias.
AUTHORS: Ammer, John
A Model of Anomaly Discovery
We analyze a model of anomaly discovery. Consistent with existing evidence, we show that the discovery of an anomaly reduces its magnitude and increases its correlation with existing anomalies. One new prediction is that the discovery of an anomaly reduces the correlation between deciles 1 and 10 for that anomaly. Using data for 12 well-known anomalies, we find strong evidence consistent with this prediction. Moreover, the correlation between deciles 1 and 10 of an anomaly becomes correlated with the aggregate hedge-fund wealth volatility after the anomaly is discovered. Our model also sheds light on how to distinguish between risk- and mispricing-based anomalies.
AUTHORS: Liu, Qi; Yan, Hongjun; Lu, Lei; Sun, Bo
Interest on Reserves and Arbitrage in Post-Crisis Money Markets
Currently, Eurodollars and fed funds markets combined trade about $220 billion in funds daily, the vast majority of which with overnight tenor. In this paper, we document several features of these wholesale unsecured dollar funding markets. Using daily confidential data on wholesale unsecured borrowing and reserve balances, we show that foreign banks, which make up most of the trading volumes in these markets, keep around 99% of each additional Eurodollar and 80% of each fed fund borrowed as reserve balances. With these risk-free trades, banks earn the spread between interest on reserves and the borrowing rate. Relative to foreign banks, large domestic institutions borrow less often, but when they do, they keep around 99% of each additional Eurodollar or fed fund raised as reserves. Small domestic banks do not display any correlation between net borrowing and their reserves accumulation. We also discuss how regulatory costs affect trading patterns and interest rate differentials in wholesale dollar funding markets.
AUTHORS: Macchiavelli, Marco; Keating, Thomas
Efficient resolution of moral hazard under no arbitrage: risk premium, volatility and leverage
AUTHORS: Acharya, Sankarshan
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 model that incorporates an early liquidation option. The ability of these models to explain arbitrage trades, however, is relatively low.
AUTHORS: Neal, Robert