Exploit Arbitrage Opportunities Research Articles

High Frequency Statistical Arbitrage Via the Optimal Thermal Causal Path

We consider the problem of identifying similarities and causality relationships in a given set of financial time series data streams. We develop further the “Optimal Thermal Causal Path” method, which is a non-parametric method proposed by Sornette et al. The method considers the mismatch between a given pair of time series in order to identify the expected minimum energy path lead-lag structure between the pair. Traders may find this a useful tool for directional trading, to spot arbitrage opportunities. We add a curvature energy term to the method and we propose an approximation technique to reduce the computational time. We apply the method and approximation technique on various market sectors of NYSE data and extract the highly correlated pairs of time series. We show how traders could exploit arbitrage opportunities by using the method.

Positive feedback trading in stock index futures: International evidence

Using a simple intertemporal asset pricing model with heterogeneous agents, this paper addresses the issue of trend-chasing investor behavior in stock index futures markets. There is strong evidence of positive feedback trading in the majority of 32 emerging and mature markets. Trend-chasing appears most pronounced after price drops during periods of financial crisis. Our empirical findings are of great concern for investors who want to use index futures as an instrument to hedge risk or exploit arbitrage opportunities. They also have implications for the debate on destabilizing effects of futures trading.

A Thought or Two for Mutual Funds

The mutual fund industry has not been able to add value to investors through performance. The objective of this article is to direct the attention of the mutual fund industry, its regulators, and clients to lessons that can be learned from the hedge fund industry. The lessons are synthesized from the findings of a number of published empirical research articles coupled with significant developments in the fund management industry. In an op-ed letter to the WSJ Mr. John Bogle eloquently describes the state of affairs in the mutual fund industry by associating it with the Emperor9s New Clothes syndrome. He reports that the costs of running an equity mutual fund is about 3%. These costs are at all-time highs. In addition, published research shows that the key factor that determines whether or not a mutual fund makes use of derivatives is membership in a given family of mutual funds. Mutual funds tend to also adopt a herd behavior in security research and selection and performance management. The compensation of the mutual fund manager is based on assets under management with no link to fund performance. Mutual fund investment strategies, unlike hedge fund strategies, are far less flexible. Hedge funds tend to generally perform well in up as well as down markets. Hedge funds sell short, leverage, use derivatives, control redemptions, and tie compensation to performance. Hedge funds use these tools for exploiting arbitrage opportunities created by indexing, herding of performance, herding of security selection, and rigid legal and institutional structures. Hedge fund managers are exposed to idiosyncratic risk. The mutual fund industry along with its key constituents, need to explore new avenues for adding value. <b>TOPICS:</b>Mutual funds/passive investing/indexing, mutual fund performance

The Limits of Arbitrage: Evidence from Fundamental Value-to-Price Trading Strategies

Shleifer and Vishny (1997) argue that arbitrage can be both costly and risky. As a result, arbitrageurs will not exploit arbitrage opportunities if the costs and risk of arbitrage exceed its benefits, thereby allowing mispricing to survive for long periods of time. Frankel and Lee (1998) document that the fundamental value-to-price (Vf/P) ratio predicts future abnormal returns for up to three years, where Vf is an estimate of fundamental value based on a residual income model that uses analyst earnings forecasts. Ali, Hwang and Trombley (2003a) further show that their results seem consistent with the mispricing explanation rather than with the risk explanation of the Vf/P effect. Thus, the Vf/P effect provides a good means to examine the limits of arbitrage. We find that the Vf/P effect is extremely weak in stocks of old age (measured by the history of listing), low investor sophistication, high divergence of opinion, high idiosyncratic return volatility, and high transaction costs. Further analysis shows that firm age, earnings quality, and divergence of opinion have incremental power beyond other measures of risk in explaining the cross-sectional variation in the Vf/P effect. Our results appear to be consistent with the argument of the limits of arbitrage. More specifically, when arbitrageurs exploit arbitrage opportunities, they seek to avoid mispriced stocks with the greatest arbitrage risk. JEL Classification: G10, G11, G14

ON THE IMPACT OF "CALLBACK" COMPETITION ON INTERNATIONAL TELEPHONY ⁄

In this paper we build a simple three-country model to evaluate the impact of “callback” on international telephony. The effects on both accounting rates and collection prices are studied. Callback firms exploit arbitrage opportunities in collection prices among countries, rerouting calls that originate in countries with high prices for international phone calls via countries with low prices. Contrary to what is commonly perceived, we show that callback tends to magnify the distortions associated with the current accounting rate regime. In particular, callback puts upward pressure on low price countries’ accounting rates and on collection charges. Callback companies are assumed to enjoy a volume price discount on each rerouted call; we show that the larger the price discount offered to callback companies, the higher the prices for international calls in the country hosting callback.

Discretized reality and spurious profits in stochastic programming models for asset/liability management

In the literature on stochastic programming models for practical portfolio investment problems, relatively little attention has been devoted to the question how the necessarily approximate description of the asset-price uncertainty in these models influences the optimal solution. In this paper we will show that it is important that asset prices in such a description are arbitrage-free. Descriptions which have been suggested in the literature are often inconsistent with observed market prices and/or use sampling to obtain a set of scenarios about the future. We will show that this effectively introduces arbitrage opportunities in the optimization model. For an investor who cannot exploit arbitrage opportunities directly because of market imperfections and trading restrictions, we will illustrate that the presence of such arbitrage opportunities may cause substantial biases in the optimal investment strategy.

Discretized Reality and Spurious Profits in Stochastic Programming Models for Asset/Liability Management

In the literature on stochastic programming models for practical portfolio investment problems, relatively little attention has been devoted to the question how the necessarily approximate description of the asset-price uncertainty in these models influences the optimal solution. In this paper we will show that it is important that asset prices in such a description are arbitrage-free. Descriptions which have been suggested in the literature are often inconsistent with observed market prices and/or use sampling to obtain a set of scenarios about the future. We will show that this effectively introduces arbitrage opportunities in the optimization model. For an investor who cannot exploit arbitrage opportunities directly because of market imperfections and trading restrictions, we will illustrate that the presence of such arbitrage opportunities may cause substantial biases in the optimal investment strategy.

Foreign and Domestic Divestments: Evidence on Valuation Effects of Plant Closings

This study examines the valuation consequences of domestic and foreign divestments by comparing the stock price reaction to announcements of domestic plant closings and foreign plant closings. A domestic plant closing could indicate firm-wide problems and impending firm deterioration. A foreign plant may serve to exploit arbitrage opportunities specific to that plant location. Closing a foreign plant need not signify firm-wide problems. Our comparison of stated reasons for closings supports these propositions. Therefore, foreign plant closing announcements should produce a smaller stock price decline that domestic plant closing announcements. Empirical results indicate a significant negative stock price reaction for domestic plant closings and an insignificant negative stock price reaction for foreign plant closings. Differences in stock price reaction remain after controlling for firm-specific factors.