Arbitrage Risk Research Articles

Arbitrage risk and the turnover anomaly

A strong turnover premium exists such that stocks with lower turnover have higher future returns in the 5years following their formation than those with higher turnover. This turnover premium cannot be explained by existing asset-pricing models, a risk-based liquidity factor, or anomalies such as size, book-to-market ratio, or momentum. Further analysis indicates that the turnover premium is greater for stocks with higher idiosyncratic volatility, higher transaction costs, lower institutional ownership, and lower investor sophistication, which implies it is consistent with the mispricing explanation based on arbitrage risk.

Bank Debt Regulations: Implications for Bank Capital and Bond Risk

We study how optimal bank capital and bond risk are inuenced by deposit insurance, implicit guarantees, depositor preference, asset encumbrance, and bail-in resolution frameworks. We nd that these features of bank nancing change the optimal amount of bank capital. The net eect on bond debt risk and valuation is small, while the eects on shareholder value and public sector liability value are significant. A gap between optimal capital and required capital represents a cost to shareholders and increases the risk of regulatory arbitrage. Based on a small sample of European banks, we nd support for the

Ex-dividend prices and investor trades: Evidence from Taiwan

Based upon an examination of 987 ex-dividend events that took place on the Taiwan Stock Exchange between January 1992 and December 2006, we find that differential taxes are an important factor affecting share prices and the behavior of investors around the ex-dividend day. Ex-day price drop ratio increases with the average investor's preference for dividend relative to capital gains. Excess volume around the ex-dividend day is positively correlated with the degree of tax heterogeneity and the gains from dividend-capturing activities, and is negatively associated with arbitrage risk and transaction costs. We also find that high tax-bracket investors sell shares cum-dividend, subsequently reversing to buy shares on the ex-dividend day, whereas low tax-bracket individual investors, proprietary traders and corporate shareholders trade in the opposite direction. Overall, our results provide support for the dynamic dividend clientele hypothesis.

What affects the cool-off duration under price limits?

Price limits supposedly provide a cool-off period that allows investors to reassess the market conditions. They represent an implementation risk, a special form of arbitrage risk, that impedes arbitrageurs from engaging in arbitrage activities to correct for potential mispricing. We conjecture that the cool-off period would be lengthier for stocks that are subject to higher degrees of arbitrage risk and investor sentiment, and that the effect of arbitrage risk is stronger in up-limit hits because of higher short-sale restriction involved. Based on a sample of intraday data from the Taiwan Stock Exchange, we find that stocks with smaller capitalizations and higher idiosyncratic risk tend to have longer limit-hit durations, consistent with the behavioral argument. The empirical results have important policy implications for stock market regulations.

Creating a Safer Financial System: Will the Volcker, Vickers, and Liikanen Structural Measures Help?

The U.S., the U.K., and more recently, the E.U., have proposed policy measures directly targeting complexity and business structures of banks. Unlike other, price-based reforms (e.g., Basel 3 and G-SIFI surcharges), these proposals have been developed unilaterally with material differences in scope, design and implementation schedules. This may exacerbate cross-border regulatory arbitrage and put a further burden on consolidated supervision and cross-border resolution. This paper provides an analysis of the potential implications of implementing different structural policy measures. It proposes a pragmatic and coordinated approach to development of these policies to reduce risk of regulatory arbitrage and minimize unintended consequences. In doing so, it also aims to identify a set of common policy measures that countries could adopt to re-scope bank business models and corporate structures.

An Option-Based Approach to Risk Arbitrage in Emerging Markets: Evidence from Taiwan Takeover Attempts

Predicting the accuracy rate of takeover completion is the major key to risk arbitrage returns. In emerging markets, data on takeover attempts are either unavailable or of poor quality. Therefore, this paper proposes an option-based approach to improve the accuracy of prediction. Empirical research on Taiwan takeovers shows that by this approach, the accuracy rate is 71.15%—considerably higher than the average of 54.81% using qualitative models. There exist, on average, three opportunities to close arbitrage positions, at a time before completion dates, when the target and acquiring stock prices converge. The annualized abnormal return is 42.19% greater than it would otherwise be. Copyright © 2012 John Wiley & Sons, Ltd.

Illusion of Growth: Merger-Related Transitory Growth and Its Implications for Growth and Accrual Mispricing

Prior literature in accounting and financial economics measures asset growth as year-over-year growth in total assets. Such growth estimates are upward biased when firms engage in mergers and acquisitions. We decompose asset growth into merger-related and organic growth components, and find that merger-related growth is less persistent than organic growth. The merger-related growth is positively associated with analysts’ optimism in earnings forecasts and stock recommendations, and is a strong predictor of future returns. Furthermore, such return predictability is exhibited by firms that do not transparently disclose the merger-related and organic growth components. This finding is consistent with investors with limited attention playing a role in mispricing. Portfolio asset pricing tests reveal that priced risk factors do not explain this growth pricing anomaly. Stocks with high merger-related growth tend to be associated with higher trading costs and arbitrage risk, which contributes to the persistence of this mispricing over time.

Applying the Teachings of Behavioural Finance to Risk Arbitrage Strategy

Contrary to classic financial strategy based on the rational behaviour of economic agents, behavioural finance offers a more pragmatic vision of markets, notably by applying psychology.It is now fairly widely acknowledged that the assumption of market efficiency upon which classic financial strategy is based is not a good way to explain the operation of capital markets. Conversely, behavioural finance is able to furnish some very interesting answers by taking a fresh look at the decision-making process of investors. Many studies have thereby made the link between the forming of prices on equity markets and the behavioural biases of long only and long-short managers. Yet to our knowledge, there are no research papers that associate both behavioural finance and the alternative strategy of risk arbitrage.In this document, we therefore propose to apply the cognitive science approach to the study of this theory, which we have been using in our funds for more than 10 years. From the preparation of a M&A deal by a potential buyer to the establishment of the strategy in the portfolio by the arbitrageur, all the players on the chain are ideal subject matter for behavioural finance. Indeed, they share the same characteristic of having to make important decisions in an uncertain, probabilistic world that is saturated with information.To begin with, we present the general principles of behavioural finance by rounding up the scientific literature on the subject. In particular, we see how the main biases of financial market players are organised. We then go on to illustrate these biases with concrete examples drawn from the experience of our risk arbitrage management team. We conclude by showing that behavioural finance can be a precious tool in the management of a risk arbitrage portfolio.

Do funds follow post-earnings announcement drift?

We show that actively managed US hedge funds, on average, trade on the post-earnings announcement drift anomaly more aggressively than mutual funds. Both mutual and hedge funds that actively trade on drift anomaly face higher arbitrage risk. However, arbitrage risk reduces mutual funds’ willingness to buy high-SUE stocks with high return volatility, but not hedge funds.

The evolving beta-liquidity relationship of hedge funds

Hedge funds are known to have liquidity-timing capability, but this might be conditional on aggregate market conditions. To test this, we analyze changes in the relation between hedge funds' stock market exposure and aggregate stock market liquidity. Employing an optimal changepoint approach, we find that equity-oriented hedge funds display a significant shift in liquidity-timing behavior after the major market microstructure changes in the year 2000. The shift is from a negative relation between market beta and liquidity towards a positive relation. We rule out a mechanistic explanation of the results by computing the returns to several familiar risk arbitrage strategies, finding in them no evidence of a similar shift in liquidity timing.

Risk Arbitrage in the Super Bowl and Playoffs and in the US Presidential Election and the Current Economic Outlook

Risk Arbitrage in the Super Bowl and Playoffs and in the US Presidential Election and the Current Economic Outlook

Dynamic Strategic Arbitrage I: Price Effects

Real-world arbitrage often involves a limited number of large financial intermediaries (e.g. dealers, hedge funds) with price impact. I study a multi-period model of imperfectly competitive arbitrage, in which supply shocks generate price di fferences between two identical assets traded in segmented markets. Arbitrageurs seeking to exploit these price differences split up their orders to limit their price impact. I show that this mechanism and specific supply shock patterns can explain the empirical evidence that i) identical assets can trade at di fferent prices, ii) these price differences revert slowly over time, as if capital was slow-moving, iii) the sign of price differences can switch over time, iv) market depth is time-varying. The model also off ers new testable predictions, in particular that the market structure is a driver of arbitrage speed and changes in market depth, and shows that strategic arbitrageurs do not necessarily o ffset increases in arbitrage risk.

Arbitrage Risk and Market Efficiency – Applications to Securities Class Actions

Measuring the efficiency of the market for a stock is important for a number of reasons, but such measurements have been widely utilized in securities class action litigation, particularly to justify certification of cases as appropriate for class action treatment. We provide a general methodology to measure the arbitrage risk, which is a negative proxy for the market efficiency, of a stock for any relevant period. We apply this methodology to calculate the arbitrage risk of each U.S. exchange-listed common stock for every calendar year from 1988 to 2010. We find that market efficiency is significantly affected by turnover (negatively), the number of market makers for Nasdaq stocks (negatively), and serial correlation in the Capital Asset Pricing Model of the stock (positively). These findings seem inconsistent with “conventional wisdom” and with the understanding that courts use in applying notions of market efficiency to class certification decisions, but we show that our findings are consistent with economic logic. The relations between market efficiency and market capitalization (positive), bid-ask spread (negative) and institutional ownership (positive) are consistent with conventional wisdom. The impact on market efficiency of the number of securities analysts following a stock and the public float ratio of a stock are of ambiguous significance.

Arbitrage Risk and Market Efficiency – Applications to Securities Class Actions

Measuring the efficiency of the market for a stock is important for a number of reasons, but such measurements have been widely utilized in securities class action litigation, particularly to justify certification of cases as appropriate for class action treatment. We provide a general methodology to measure the arbitrage risk, which is a negative proxy for the market efficiency, of a stock for any relevant period. We apply this methodology to calculate the arbitrage risk of each U.S. exchange-listed common stock for every calendar year from 1988 to 2010. We find that market efficiency is significantly affected by turnover (negatively), the number of market makers for Nasdaq stocks (negatively), and serial correlation in the Capital Asset Pricing Model of the stock (positively). These findings seem inconsistent with “conventional wisdom” and with the understanding that courts use in applying notions of market efficiency to class certification decisions, but we show that our findings are consistent with economic logic. The relations between market efficiency and market capitalization (positive), bid-ask spread (negative) and institutional ownership (positive) are consistent with conventional wisdom. The impact on market efficiency of the number of securities analysts following a stock and the public float ratio of a stock are of ambiguous significance.

Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle

Many investors purchase stock but are reluctant or unable to sell short. Combining this arbitrage asymmetry with the arbitrage risk represented by idiosyncratic volatility (IVOL) explains the negative relation between IVOL and average return. The IVOL-return relation is negative among overpriced stocks but positive among underpriced stocks, with mispricing determined by combining 11 return anomalies. Consistent with arbitrage asymmetry, the negative relation among overpriced stocks is stronger, especially for stocks less easily shorted, so the overall IVOL-return relation is negative. Further supporting our explanation, high investor sentiment weakens the positive relation among underpriced stocks and, especially, strengthens the negative relation among overpriced stocks.

The Exchange Rate Effect of Multi-Currency Risk Arbitrage

This paper documents how currency speculators trade when international capital flows generate predictable exchange rate movements. The redefinition of the MSCI world equity index in December 2000 provides an ideal natural experiment identifying exogenous capital flows of index tracking equity funds. Currency speculators are shown to front-run international capital flows. Furthermore, they actively manage the portfolio risk of their speculative positions through hedging positions in correlated currencies. The exchange rate effect of separate risk hedging is economically significant and amounts to a return difference of 3.6 percent over a 5 day event window between currencies with high and low risk hedging value. The results of the classical event study analysis are confirmed by a new and more powerful spectral inference isolating the high frequency cospectrum of currency pairs. The evidence supports the idea that international currency arbitrage is limited by the speculators' risk aversion.

Market Liquidity and Exposure of Hedge Funds

Hedge funds are known to have liquidity timing capability, but this might be changing with aggregate market conditions. To test this, we analyze changes in the relation between hedge funds’ stock market exposure and aggregate stock market liquidity. Employing an optimal changepoint approach we find that equity-oriented hedge funds display a significant shift in liquidity timing behavior after the major market microstructure changes in the year 2000. The shift is from a negative relation between market beta and liquidity towards a positive relation. We rule out a mechanistic explanation of the results by computing the returns to several familiar risk arbitrage strategies and find no evidence of a similar shift in liquidity timing in them.

A Financial Economic Theory of Punitive Damages

This Article provides a financial economic analysis of punitive damages. The core problem, as the Supreme Court acknowledged in Exxon Shipping Co. v. Baker, is not the systemic amount of punitive damages in the tort system; rather, it is the risk of outlier outcomes. Low frequency, high severity awards are unpredictable, cause financial distress, and beget social cost. By focusing only on offsetting escaped liability, the standard law and economic theory fails to account for the core problem of variance. This Article provides a risk arbitrage analysis of the relationship between variance, litigation valuation, and optimal deterrence. Starting with settlement dynamics, it shows that punitive damages beget problematic risk arbitrage opportunities, which systemically produce under- and over-valuation of cases. These effects yield inefficient pricing in the litigation system. Properly conceptualized and applied, punitive damages can mitigate risk arbitrage that skews actual results from the prescriptions of optimal liability and deterrence. The modern Supreme Court jurisprudence is flawed because it is overbroad. Single-digit multiplier caps underdeter defendants in most cases of ordinary liability because punitive damages do not sufficiently offset a defendant’s risk arbitrage opportunity gained from a lower litigation risk exposure. When liability is catastrophic, however, punitive damages overdeter defendants, even with a single-digit ratio limit, because they impart severe economic cost of financial distress in addition to the monetary cost of the judgment. These additional economic costs must be credited toward the calculus of cost internalization and optimal deterrence. Thus, a calibrated risk-based theory is needed to support legal limitations on punitive damages.

Fundamental Analysis, Institutional Investment, and Limits to Arbitrage

Abstract: Previous research shows that fundamental signals (financial ratios) derived from publicly available financial statements can predict future abnormal stock returns. This paper examines whether institutional investors trade on these fundamental signals and the implications of institutional investors’ trading for stock valuation. We provide evidence that transient institutional investors (institutions who actively trade securities for short‐term returns) trade on fundamental signals. We also show that the abnormal returns associated with fundamental signals increase with transaction costs and arbitrage risk, indicating the existence of limits to arbitrage for this investment strategy. We further document that transient institutional investors’ trades help reduce the returns related to fundamental signals. This paper provides evidence helping to explain the abnormal returns associated with fundamental signals and contributes to our understanding of institutional investors’ role in enhancing market efficiency.

Analysis of Improved Bids in the Scope of a Risk Arbitrage Strategy

This document is a study of improved bids observed during announced mergers & acquisitions of listed companies. The scope of the analysis is the North American market (US and Canada) over the 1998-2011 period. An improved bid is defined as an improvement on the terms of the initial bid for a target either by the buyer or by a third party.In the scope of a risk arbitrage strategy, improved bids are important events, since they offer particularly interesting risk/return, similar to buying a call option. This document therefore aims to analyse improved bids from the point of view of an investor setting up an arbitrage strategy.The main conclusions are as follows: i) improved bids account for about 12% of finalised deals, ii)prevailing market conditions on equity and bond markets have an impact on the volume of improved bids as well as the observed yields. For example, towards the top of equity market cycles, the number of improved bids is particularly high. Conversely, the 2008 liquidity crisis led to a dramatic fall in yields on potential improved bid situations, iii) the market is efficient when it forecasts the outcome of certain improved bids. The higher the target’s shares trade above the offer price in the days following the announcement, the likelier it is that the deal will have a favourable outcome for the investor, iv) even though improved bids are most commonly seen in hostile bid situations, it is hard to establish the typical profile for an improved bid: neither the payment type nor the sector of the target, nor the nationality of the buyer are deciding factors. Overall, the phenomenon is therefore difficult to forecast.