Arbitrage Relation Research Articles

Causality of price movements in VIX exchange-traded products and VIX futures contracts

PurposeThe authors analyse six actively traded VIX Exchange Traded Products (ETPs) including 1x long, −1x inverse and 2x leveraged products. The authors assess their impact on the VIX Futures index benchmark.Design/methodology/approachLong-run causal relations between daily price movements in ETPs and futures are established, and the impact of rebalancing activity of leveraged and inverse ETPs evidenced through causal relations in the last 30 min of daily trading.FindingsHigh frequency lead lag relations are observed, demonstrating opportunities for arbitrage, although these tend to be short-lived and only material in times of market dislocation.Originality/valueThe causal relations between VXX and VIX Futures are well established with leads and lags generally found to be short-lived and arbitrage relations holding. The authors go further to capture 1x long, −1x inverse as well as 2x leveraged ETNs and the corresponding ETFs, to give a broad representation across the ETP market. The authors establish causal relations between inverse and leveraged products where causal relations are not yet documented.

A Note on the Empirical Relation between Oil Prices and the Value of the Dollar

This paper offers an empirical characterization of the relation between the international price of oil and exchange rates that is both useful and reliable. Our characterization is useful because it rests on information of asset prices that are determined in functioning asset markets. Our characterization is reliable because its maintained assumptions are not rejected by the data. Four features differentiate our work from previous analyses. First, our reliance on bilateral rates opens previously ignored financial arbitrage opportunities between oil prices and exchange rates. Second, our emphasis on statistical testing makes our characterization empirically reliable. Specifically, we use a vector-error correction modeling strategy in which both oil prices and exchange rates are endogenous. This framework allows testing for the existence of an arbitrage relation, for the direction of causality, for parameter constancy, for white noise residuals, and for forecast accuracy. Third our reliance on data through 2020 makes our analysis timely. Fourth, to emphasize the advantages of our approach, we compare our results to those derived for formulations relying on effective exchange-rate indexes.

Duration dependence among agricultural futures with different maturities

ABSTRACTThe purpose of this paper is to analyse the interdependence of price durations among agricultural futures contracts with different maturities. We apply an extended autoregressive conditional duration (ACD) model to storable and non-storable agricultural commodities. Using Chicago Mercantile Exchange (CME) Best-Bid-Best-Offer (BBO) futures data, we find duration dependence for corn, wheat, live cattle, and lean hog. Somewhat surprisingly, we do not find differences between storable and non-storable commodities. The main contribution of our analysis is to provide empirical evidence that short-term effects motivated by market microstructure theory do not outweigh arbitrage relations along the forward curve as suggested by theories of storage and normal backwardation.

The CDS‐bond basis

AbstractWe investigate the cross‐sectional variation in the credit default swap (CDS)‐bond bases and test explanations for the violation of the arbitrage relation between cash bond and CDS contract, which states that the basis should be zero in normal conditions. The evidence is consistent with “limits to arbitrage” theories in that deviations are larger for bonds with higher frictions as measured by trading liquidity, funding cost, counterparty risk, and collateral quality. Surprisingly, we find the basis to be more negative when bond lending fee is higher suggesting that arbitrageurs are unwilling to engage in a negative basis trade when short interest on the bond is high.

Positive Liquidity Spillovers from Sovereign Bond-Backed Securities

There are competing arguments about the likely effects of Sovereign Bond-Backed Securitisation on the liquidity of sovereign bond markets. By analysing hedging and diversification opportunities, this paper shows that positive liquidity spillovers would dominate or at least constrain the extent of any negative effects. This relies on dealers using Sovereign Bond-Backed Securities (SBBS) as instruments to hedge inventory risk and it assumes that they diversify their activities widely across euro area sovereign markets. Through a simple arbitrage relation, the existence of low-cost hedging and diversification opportunities limits the divergence of bid-ask spreads between national and SBBS markets. This is demonstrated using estimated SBBS yields (a la Schonbucher (2003)).

Covered Interest Parity Arbitrage and Long-Run Relation between Spot and Forward Rates in Foreign Exchange (Rupee/Dollar) Market in India-Study of Market Efficiency with Arima (p, d, q) Forecasting

The study examines the relation that spot exchange rate maintains with contemporaneous and one – month lagged forward rates in the framework of covered interest parity arbitrage in Indian foreign exchange (rupee/dollar) market from 3 rd January, 2011 to 2 nd November, 2015. ARIMA (4, 1, 0) stochastic structure of monthly spot rate (S t ) has been used to generate one – period ahead forecast (S e t+1 ) series. These forecasts are MMSE forecasts and ‘Rational’ by nature. The study shows that one – month lagged forward rate maintains an independent long – run stable relation with spot rate while there exists no co-integrating relation between spot rate and contemporaneous forward rate. One – period lagged forward rate is an optimal forecast of the next period spot rate in the sense that it will be proved wrong only to the extent ofa white noise error term. Risk premium is absent and CIRAP holds in the market such that lagged forward exchange rate on average equals the spot rate in the long – run. There exists no scope for reaping arbitrage profit arising out of the difference between forward rate and corresponding spot rate. This testifies for the ‘efficiency’ of Indian foreign exchange (rupee/dollar) market.

The Determinants of the CDS-Bond Basis During the Financial Crisis of 2007-2009

We investigate the cross-sectional variation in the CDS-bond basis, which measures the difference between credit default swap spread and cash-bond implied credit spread. We test several explanations for the violation of the arbitrage relation between cash bond and CDS contract, which states that, in normal conditions, the basis should be zero. The evidence is consistent with 'limits to arbitrage' theories in that deviations are larger for bonds with higher frictions, as measured by trading liquidity, funding cost, counterparty risk, and collateral margin.

The CDS-Bond Basis During the Financial Crisis of 2007-2009

We investigate both the time-series and cross-sectional variation in the CDS-bond basis, which measures the difference between the CDS spread and cash-bond implied credit spread, for a large sample of individual firms during the financial crisis. We test several possible explanations for the violation of the arbitrage relation between cash bond and CDS contract that would, in normal conditions, drive the basis to zero. Our findings do not uncover a clear single explanatory factor for the anomaly. Rather they point towards several drivers related to funding risk, counterparty risk and collateral quality that force the individual bond basis into negative territory at different phases of the crisis.

The pricing of dividend futures in the European market: A first empirical analysis

This article is the first to study empirically the pricing of the Euro Stoxx 50 dividend futures, introduced at the European Exchange (Eurex) in mid-2008. These instruments are an easy means of obtaining exposure to the future dividends of the index constituents for hedging and speculation purposes. Trading figures thus far show a viable interest of market participants in this innovation. Based on straightforward and model-free replication arguments, this study compares prices of the dividend futures to those of hedging portfolios built on exchange-traded index options. The analysis shows substantial pricing imbalances, and hence violations of arbitrage relations between both derivatives markets for a set of contract maturities. This phenomenon cannot be fully explained by transactions costs and other potential trading constraints.

A No Arbitrage Fractional Cointegration Analysis of the Range Based Volatility

The no arbitrage relation between futures and spot prices implies an analogous relation between futures and spot volatilities as measured by daily range. Long memory features of the range-based volatility estimators of the two series are analyzed, and their joint dynamics are modeled via a fractional vector error correction model (FVECM), in order to explicitly consider the no arbitrage constraints. We introduce a two-step estimation procedure for the FVECM parameters and we show the properties by a Monte Carlo simulation. The out-of-sample forecasting superiority of FVECM, with respect to competing models, is documented. The results highlight the importance of giving fully account of long-run equilibria in volatilities in order to obtain better forecasts.

Index Participation Units and the Structure of Equity Market Demand: Evidence from New Issues and Redemptions of SPDRs

This study examines the effects of trading in Standard and Poor's Depository Receipts on the pricing efficiency of the index options markets. Using the put-call parity model's no-arbitrage arguments, and intra-day S&P 500 index option data, three boundary conditions are formulated and tested for a total of 119,470 portfolios using intradaily data. Problems of non-synchronous prices are reduced by using intradaily data and also by considering only trades that occur at precisely the same time to the second. The tests indicate that there are significant violations of the arbitrage relations. After accounting that transactions costs including the bid-ask spread, it is apparent that the magnitude and frequency of violations of the arbitrage bounds has decreased, since the introduction of SPDRs. However, the dollar size of the violations that persist through time is substantial and may be worthy of future investigation.

COINTEGRATION AND SETTLEMENT OF COMMODITY FUTURES CONTRACTS

Weekly live cattle prices in various markets would be expected to share common trends, i.e., they cannot be driven by separate nonstationarities because at some point the prices will diverge sufficiently for it to be economic to cross-ship the cattle, or at least the beef. This paper extends previous bivariate work to a multivariate analysis that is capable of modeling the multiple market linkages in prices for many geographical regions. The empirical estimation represents the application of an innovation on Aoki's Linear Systems State Space model that allows determination of long- and short-run dynamics common to multiple series. The common dynamics permit characterization of the multiple markets with a limited number of states (sufficient statistics for the past), resulting in dynamic arbitrage relations between the series. A nonparametric test is used to evaluate the value of expected arbitrage forecasts implied by the structure of the model. The arbitrage relationship also is employed to generate efficient discounts/premiums for either physical delivery or cash settlement of futures contracts. The proposed settlement mechanism accounts for spatial arbitrage opportunities and therefore better represents the true geographical discounts faced by traders in individual markets.

Regional Price Dynamics and Countervailing Duties: Did the Canada-U.S. Hog/Pork Dispute Have a Permanent Impact?

Leamer (1988:53) argues that permanent trade barriers trigger stronger and more lasting responses than temporary ones. We analyze the effects of U.S. countervailing duties (CVDs) imposed on Canadian hog and pork exports by testing the stability of long run arbitrage/cointegration relations between U.S., Québec and Alberta hog prices. The CVDs induced large deviations from the long run arbitrage relations but these effects vanished with the removal of the pork CVD. Weak exogeneity tests show that the U.S. hog price did not error correct during the dispute period and confirm that CVDs contribute to insulate a large domestic market from foreign competition. [F13]

A threshold error-correction model for intraday futures and index returns

Index-futures arbitragers only enter into the market if the deviation from the arbitrage relation is sufficiently large to compensate for transaction costs and associated interest rate and dividend risks. We estimate the band around the theoretical futures price within which arbitrage is not profitable for most arbitragers, using a threshold autoregression model. Combining these thresholds with an error-correction model, we show that the impact of the mispricing error is increasing with the magnitude of that error and that the information effect of lagged futures returns on index returns is significantly larger when the mispricing error is negative. © 1998 John Wiley & Sons, Ltd.

A threshold error‐correction model for intraday futures and index returns

Index-futures arbitrageurs enter into the market only if the deviation from the arbitrage relation is large enough to compensate for transaction costs and associated interest-rate and dividend risks. Using a threshold autoregression model for the mispricing error, we estimate the band around the theoretical futures prices within which arbitrage is not profitable for most arbitrageurs. Combining these thresholds with an error correction model, we can make a distinction between the effects of arbitrageurs and infrequent trading on index and futures returns. The impact of the mispricing error on the returns is increasing with the magnitude of the mispricing error, and the effect of futures returns on index returns is significantly larger when the basis is negative.

Rational Expectations, Market Fundamentals and Housing Price Volatility

This paper derives a forward‐looking rational expectations house price model and empirically tests its ability to explain short‐run fluctuations in real house prices. A novel approach to proxying the imputed rents of owner‐occupied housing, as a function of observable housing market fundamentals, is combined with a housing market arbitrage relation to derive a present value model for real house prices. Tests of the rational expectations, nonlinear cross‐equation restrictions reject the joint null hypothesis of rational expectations and the asset‐based housing price model for quarterly, single‐detached house prices in the city of Vancouver, British Columbia from 1979–1991. The model fails to fully capture observed house price dynamics in two real estate booms but tracks real house prices well in less volatile times, suggesting that prices may temporarily deviate from fundamental values in real estate price cycles.

Is the Gilt-Equity Yield Ratio Useful for Predicting UK Stock Returns?

The ratio of a long government bond yield to the equity market dividend yield, the Gilt-Equity Yield Ratio (GEYR), is commonly used by analysts in the UK as a means of determining the cheapness of equity investment relative to investment in gilts. Analysts use the ratio to predict future movements in equity prices using buy/sell thresholds, implicitly assuming that there is a long-run arbitrage relation between the equity market and the government bond market. A formal econometric analysis confirms that the GEYR is indeed a useful predictor of equity returns in the UK.

Stochastic Speculative Price

Because a commodity like wheat can be carried forward from one period to the next, speculative arbitrage serves to link its prices at different points of time. Since, however, the size of the harvest depends on complicated probability processes impossible to forecast with certainty, the minimal model for understanding market behavior must involve stochastic processes. The present study, on the basis of the axiom that it is the expected rather than the known-for-certain prices which enter into all arbitrage relations and carryover decisions, determines the behavior of price as the solution to a stochastic-dynamic-programming problem. The resulting stationary time series possesses an ergodic state and normative properties like those often observed for real-world bourses.