Arbitrage Risk Research Articles

The Influence of Deleveraging the Excessive Debt Firms on Investment Efficiency

Under China's deleveraging policy scenario, this study analyzes the deleveraging effect of excessive leverage firms on investment efficiency and the influence of arbitrage risk on the deleveraging effect. The results show that deleverage lowers over-investment and, to some extent, alleviates under-investment. Deleverage can further bolster corporate performance while boosting investment efficiency. In addition, arbitrage risk in the capital market negatively moderates the impact of deleveraging on investment efficiency, specifically through the transaction cost mechanism. Arbitrage risk weakens the deleveraging effect on investment efficiency mainly through managerial catering to short-term investor sentiment. This study provides capital structure literature with new evidence by examining whether deleveraging to the firms’ expected capital structure influences investment efficiency. We also provide evidence that capital markets moderate the deleveraging effect by arbitrage risk.

베타의 변동성과 주식의 기대수익률

This paper presents the stocks with high volatility of beta (VolBeta) underperform those with low VolBeta in the Korean stock market. The main findings are summarized as follows: First, the portfolio with high VolBeta has lower return relative to the one with low VolBeta. The raw and Fama-French four factor risk-adjusted return on zero-cost portfolio buying the highest and selling lowest VolBeta deciles are -1.11% and -1.45%, respectively. Second, firm-level Fama-MacBeth cross-sectional regressions show negative and statistically significant relation between VolBeta in this month and the cross-section of future returns. The results are robust to controls for firm chracteristics reportedly affecting stock returns. Third, overpricing of the stocks with high VolBeta is mostly pronounced in the ones with high idiosyncratic volatility. On the contrary, overpricing disappears in the high VolBeta stocks with low idiosyncratic volatility. The results suggest stocks with higher arbitrage risk measured by idiosyncratic volatility are more likely to be mispriced, consistent with Stambaugh, Yu, Yuan(2015).

Knowledge arbitrage: what are the risks, and do they matter?

PurposeIt is largely acknowledged that arbitrating the flow of knowledge can help firms strategically leverage tacit and explicit internal knowledge. However, despite the apparent scholarly and managerial acceptance of the criticality of the flow of knowledge between various stakeholders, the academic understanding of knowledge arbitrage remains coarse-grained. There are practically no empirical insights available to unravel the consequences of firms’ knowledge arbitrage choices regarding rewards and risks. This study aims to identify the risks that emerge as firms channel the flow of knowledge from surplus to deficit areas within organizational boundaries. To this end, the authors investigate several subsumed subprocesses in knowledge arbitrage to map the associated risks.Design/methodology/approachThis study used an exploratory qualitative approach to examine the risks that emerge as firms attempt to support knowledge flows within their organizational boundaries. The data were collected through open-ended essays via an online research platform from 45 full-time employees of firms operating in different sectors. The collected data were analyzed inductively through open, axial and selective coding.FindingsThe research findings identified three key subprocesses of knowledge arbitrage: knowledge diffusion, knowledge brokering and knowledge absorption. These subprocesses are susceptible to various risks arising the form of channels, champions, sharers and receivers of knowledge flows. In general, the study showed that a firm’s decision regarding knowledge flows, such as structured or random flows, or the presence or absence of designated coordinators to broker the flow carries specific risks for both sharers and receivers. In particular, while the risks of knowledge hiding, misinformation and disinformation manifest in all three subprocesses, low employee engagement, loss of knowledge and information overload also emerged as key risks in any two of the three subprocesses.Originality/valueThis study offers valuable insights by uncovering the hitherto unexplored risks in intrafirm knowledge arbitrage. Given that knowledge is a crucial organizational tool for driving performance, innovation and competitive advantage, understanding the risks associated with intrafirm arbitrated knowledge flows can help firms anticipate and mitigate the associated adverse consequences. The findings make a novel contribution by offering (a) a comprehensive categorization of the risks associated with knowledge arbitrage rooted in processes, people and structures and (b) a macro overview of knowledge arbitrage risks associated with the processes of knowledge diffusion, knowledge brokering and knowledge absorption.

How to Make Long-Term Investments in a Stock Market? A Generic Strategy for Investors

Against the backdrop of increasingly fierce industrial competition nowadays, firms tend to have substantive business risk and/or information risk, increasing the estimation risk and limit of arbitrage for investors in their short-term investments in a stock market. It is thus important for investors to hold a long-term horizon for at least part of their investments in the stock market. This paper aims to introduce a long-term investment strategy that is practically feasible and potentially valuable to investors. To this end, we first develop a parsimonious model in which we identify the major determinants of a firm’s value. This model is used to select high-value firms from each industry for further fundamental analysis and valuation. We next expatiate on how to perform strategy analysis, accounting analysis, financial analysis, and prospective analysis, and therein apply the residual operating income valuation model, in the best possible manner to further value the selected firms and their long-term investment potential. Lastly, we expound the strategy of forming and adjusting a long-term investment portfolio in a way that potentially maximizes long-term portfolio return.

Lending on the Edge

In Australia, pawnbrokers are largely exempt from national consumer credit legislation. They are instead governed by state legislation, which affords very limited protection to consumers. This study outlines the current regulation of pawn lending and presents a qualitative profile of consumers who use pawn loans. In the absence of reliable industry data, it draws on case law, media reports, law reform submissions, previous qualitative studies and an online survey of consumers, conducted by the authors. The study argues that the light regulation of pawn lending creates a high risk of consumer harm and regulatory arbitrage by unscrupulous providers. It proposes law reforms and policy measures to address these risks and to provide more effective protection to consumers.

Takeovers, Freezeouts, and Risk Arbitrage

This paper develops a dynamic model of tender offers in which there is trading on the target’s shares during the takeover, and bidders can freeze out target shareholders (compulsorily acquire remaining shares not tendered at the bid price), features that prevail on almost all takeovers. We show that trading allows for the entry of arbitrageurs with large blocks of shares who can hold out a freezeout—a threat that forces the bidder to offer a high preemptive bid. There is also a positive relationship between the takeover premium and arbitrageurs’ accumulation of shares before the takeover announcement, and the less liquid the target stock, the stronger this relationship is. Moreover, freezeouts eliminate the free-rider problem, but front-end loaded bids, such as two-tiered and partial offers, do not benefit bidders because arbitrageurs can undo any potential benefit and eliminate the coerciveness of these offers. Similarly, the takeover premium is also largely unrelated to the bidder’s ability to dilute the target’s shareholders after the acquisition, also due to potential arbitrage activity.

Pari-Mutuel Betting Markets: Racetracks and Lotteries Revisited

This survey discusses the state of the art in research in racetrack and lottery investment markets. Market efficiency and the pricing of various wagers are studied along with new developments since the Thaler & Ziemba (1988) review. The weak form inefficient market pricing approach using stochastic programming optimization models changed racetrack betting from handicapping to a financial market allowing professional syndicates to operate as hedge funds. Topics discussed include arbitrage and risk arbitrage, syndicates, betting exchange rebates, behavioral biases, and fundamental and mispricing information in racetrack and lottery markets. Similar models can be used to successfully trade stock market anomalies. Supplemental Materials are included online.

The Impact of Derivatives on Spot Markets: Evidence from the Introduction of Bitcoin Futures Contracts

Cryptocurrencies provide a unique opportunity to identify how derivatives impact spot markets. They are fully fungible and trade across multiple spot exchanges at different prices, and futures contracts were selectively introduced on Bitcoin (BTC) exchange rates against the U.S. dollar (USD) in December 2017. Following the futures introduction, we find a significantly greater increase in cross-exchange price synchronicity for BTC–USD relative to other exchange rate pairs as demonstrated by an increase in price correlations and a reduction in arbitrage opportunities and volatility. We also find support for an increase in price efficiency, market quality, and liquidity. The evidence suggests that futures contracts allowed investors to circumvent arbitrage frictions associated with short-sale constraints, arbitrage risk associated with block confirmation time, and market segmentation. Overall, our analysis supports the view that the introduction of BTC–USD futures was beneficial to the Bitcoin spot market by making the underlying prices more informative. This paper was accepted by Will Cong, Special Section of Management Science: Blockchains and Crypto Economics. Funding: The authors acknowledge financial support from the Global Risk Institute. P. Augustin acknowledges financial support from the Canadian Derivatives Institute and from the Canada Research Chair Program of the Social Sciences and Humanities Research Council Canada. The paper has benefited significantly from a fellow visit of P. Augustin at the Center for Advanced Studies Foundations of Law and Finance funded by the German Research Foundation, project FOR 2774, and from a visiting position of P. Augustin at the finance department of the University of Luxembourg facilitated through the Inter Mobility Programme of the Luxembourg National Research Fund. Supplemental Material: The online appendix and data are available at https://doi.org/10.1287/mnsc.2023.4900 .

International high-frequency arbitrage for cross-listed stocks

We explore high-frequency arbitrage activities on international cross-listed stocks and develop a methodology to study the effect of information latency in high-frequency trading. We derive statistical arbitrage bounds for a mean-reverting synthetic instrument engineered from cross-listed stock prices, and we propose a new strategy that takes advantage of price deviations outside these bounds. Market frictions such as trade costs, inventory control, and arbitrage risks are considered. The strategy is tested with cross-listed stocks involving three exchanges in Canada and the United States in 2019. The annual net profit with the limit order strategy is around US$6 million, whereas the market order version is not profitable because of the great interconnectedness between exchanges in our data.

The role of anchoring on investors’ gambling preference: Evidence from China

This paper examines the anchoring effect of 52-week high price on the investors’ gambling preference in the Chinese A-share market. We document the gambling preference only exists among stocks valued much lower than their 52-week high prices. Specifically, using return skewness as a proxy for lottery stocks, we find that buying stocks in the lowest skewness quintile and selling the highest earns a significant risk-adjusted return of 0.85% per month for stocks far below their 52-week high prices. By contrast, it earns an insignificant return of 0.04% per month for stocks close to their 52-week high prices. Moreover, high arbitrage risk and investor sentiment strengthen the effect of anchoring on gambling preference. Our findings are robust after considering the effects of capital gains overhang, under-reaction to news, firm’s ownership status, and China’s non-tradable share reform.

Multi-stage dynamic evolution of green financial system from the perspective of bilateral moral hazard

In order to improve the regulatory efficiency of the government in the construction process of the green financial system, the multi-stage dynamic evolution game model of green financial system from the perspective of bilateral moral risk is constructed and analyzed. It is found that cost-controllable and profitable collaborative innovation are the fundamental to realize the sustainable cooperation of green innovation between financial institutions and carbon emission enterprises. The introduction of reward and punishment mechanism and transfer payment mechanism for government is conducive to promoting the willingness of financial institutions and carbon emission enterprises to cooperate in green innovation. However, with the increase of appeal willingness of carbon emission enterprises and the cost reduction of appeal, although the risk of illegal arbitrage of financial institutions can be curbed to a certain extent, there is a risk of deterioration in the collaborative relationship between financial institutions and carbon emission enterprises.

Mediating role of profitability relating financial leverage and stock returns

PurposeThis paper aims to highlight firms' profitability as an alternative channel by which changes in leverage could affect stock returns in an imperfect market setting. The author also analytically argues that the benefits of debt, if any, may accrue beyond the usual tax benefit channel.Design/methodology/approachThe author used multivariate regression models based on firms' characteristics and the models' changes along with a two-stage least-square (2SLS) type procedure to estimate the impact of leverage changes on stock returns. The author controls for the varying arbitrage risk that is measured by forecasted idiosyncratic volatility of stock prices and overcome simultaneous or endogenous determination by using inter-temporal non-synchronous variation in leverage and control variables.FindingsThe author finds that increase in leverage increase (decrease) stock returns for firms with the gross operating profitability higher (lower) than the cost of debt. The author also finds that the variation in arbitrage risk does not substitute for the primary effect of leverage changes on stock returns.Research limitations/implicationsThe author's findings provide tacit support to the recent literature attempting to resolve the empirically puzzling pattern of the negative relationship between profitability and leverage. The findings suggest inclusion of profitability as a crucial asset-pricing factor in the contemporary empirical models.Practical implicationsThe non-trivial role of profitability in determining the effect of leverage on firms' stock returns that may be useful to managers, credit analysts and policy makers to assess the impact of net profitability on any change in leverage and its ensuing consequences on firms' value.Originality/valueThe paper develops analytical insights into the marginal role of profitability in influencing the relationship between firms' financing decisions and firms' stock returns beyond the conventional mechanisms of tax benefits, bankruptcy costs and information asymmetry.

Is it really paid for sustainable development? The economic significance of firms' green practice

AbstractFirm's green practices and sustainable development strategies are considered to have controversial impacts on its economic performance. Exploring the precise relationship between them can provide a theoretical dimension to the long‐term development of firms and the achievement of national sustainable development goals (SDGs). In this study, the authors apply the recently developed methods to test the economic significance of Chinese firms' sustainable strategies. Specifically, the authors first adopted the ESG score constructed for corporate environmental sustainability management (ESGEnv) as a proxy variable for corporate sustainability strategies and the firms' stock returns as a proxy for corporate economic effects to investigate the economic significance of firms' strategies for sustainable development. The study then confirmed that there has a positive relationship between ESGEnv and the future stock return of firms in general. Finally, the study concluded that ESGEnv can be explained by stochastic volatility, jump risk, short selling restrictions, and arbitrage risk. Furthermore, the robustness tests based on subsample and scenario grouping analysis confirmed the inconsistency in the relationship between the economic returns for the firms and the firms' green practices based their sustainable development strategies. As a result, the study contributed the literatures by clarifying the circumstances in which the firms' sustainable development strategies do have positive impacts on their economic benefits and also by providing the academy even more fuel to the already fierce debates over the firms' economic significances because of their green practices

Retail Investors and Stock Price Synchronicity

In this study, we use the number of retail investors in China’s stock market to investigate how retail investors affect stock price synchronicity. We find that a higher number of retail investors in a firm is associated with higher stock price synchronicity. Moreover, we trace this association to two sources. One is a negative effect of the number of retail investors on the probability of informed trading (PIN), suggesting that retail investors generate arbitrage risk which discourages informed trading. The other is a positive influence of the number of retail investors on price comovement (beta), resulting from correlated trading among retail investors.

The regulators’ dilemma and the global banking regulation: the case of the dual financial systems

This paper aims to contribute to the literature debate on the regulators’ dilemma affecting international financial regulations focusing on the banking regulation of dual financial systems. In this regard, the paper provides a new taxonomy of Islamic Financial Systems considering the banking regulation as a driver for the classification and a more detailed definition of dual financial systems. The literature review reveals the existence of different financial system structures affected by socio-cultural biases due to different characteristics of various countries and financial systems globally. The risk of regulatory arbitrage or over-regulation phenomena is high, stifling the growth and the level playing field for both some systemically financial systems.

Cross-sectional seasonalities and seasonal reversals: Evidence from China

We are the first to comprehensively investigate cross-sectional seasonalities and seasonal reversals in the Chinese A-share market. Empirically, utilizing monthly data from January 1995 to December 2019, we provide new supporting evidence that there are seasonalities and seasonal reversals in the cross-section. Interestingly, the occurrence of seasonal reversals takes a longer time than that of the U.S. market. Next, we explore explanations for cross-sectional seasonalities. The tests based upon macroeconomic risk, mood beta, and limits of arbitrage suggest that seasonalities are likely driven by temporary mispricing. Finally, we construct seasonality and seasonal reversal factors to study the investment value of seasonalities. We find that these factors can significantly increase the monthly Sharpe ratio by up to 0.34 and capture incremental information in predicting future returns relative to other well-known factors.

Risk Arbitrage in the 2021 NBA Championship

Mean reversion risk arbitrage is an ideal way to bet on and watch the NBA.

International High-Frequency Arbitrage for Cross-Listed Stocks

We explore latency arbitrage activities with a new arbitrage strategy that we test with high-frequency data during the first six months of 2019. We study the profitability of mean-reverting arbitrage activities of 74 cross-listed stocks involving three exchanges in Canada and the United States. Our arbitrage strategy is a hybrid between triangular arbitrage and pairs trading. We synchronize the high-frequency data feeds from the three exchange venues considering explicitly the latency that comes from the transportation of information between the exchanges and its treatment time. Other trading costs and arbitrage risks are also considered. The annual net profit of an HFT firm that uses limit orders is around CAD $8 million (USD $6 million), a result that we consider reasonable when compared with the previous literature. International latency arbitrage with market orders is never profitable.

A Risk Characterization of Regulatory Arbitrage in Financial Markets

This article analyses regulatory arbitrage in financial markets from a risk-based perspective. It assesses regulatory arbitrage in terms of the risk it may pose to the attainment of a regulatory objective, in this case financial stability. Its most distinct contribution to the literature is the application of the NOAEL approach—thus far mainly used in public health literature and regulatory toxicology—to the legal analysis and management of arbitrage risks. We propose several qualitative parameters relating to the likelihood of regulatory arbitrage and the negative impact if such arbitrage should occur. The article ultimately aims to help frame the ongoing debate about policy-making and the use of risk assessment methodologies to cope with regulatory arbitrage in financial markets.

Lottery preferences and retail short selling

Unlike developed countries, the prominent participants in the Taiwanese stock market are individual investors. This study found that retail short-sellers in Taiwan can predict stock prices and perform better with stocks held primarily by retail investors with a preference for lottery-like payoffs. Moreover, short-sellers make lower profits with stocks with lottery features in the absence of the uptick rule. The findings are robust when considering the effect of institutional short selling, alternative lottery-like measures such as retail trading activity, arbitrage risk, and distinct macroeconomic conditions. Overall, the results suggest that retail investors are not necessarily noise traders. Based on divergence-of-opinion theory (Miller, 1977), heterogeneous retail investors make trades due to their differences in sentiments. Meanwhile, retail short-sellers include professionals in profitmaking through short-selling by gauging the gambling propensity of general retail investors. Consequently, removing short-selling restrictions can increase the spillover effect of short-sellers' trading signals and help other retail investors move and adjust their investments in lottery-like stocks.