Arbitrage Process Research Articles

Are Increasing Interest Rates From Leverage Consistent with Modigliani-Miller Arbitrage?

Among the most important contributions to the finance literature is Modigliani and Miller’s seminal work on capitalstructure. As still taught in virtually all corporate finance textbooks, their famous Propositions I and II provide the foundation for the analysis of capital structure. Proposition I argues that under certain assumptions capital structure is irrelevant to the value of the firm. Proposition II describes the change in the required return to equity in response to a change in financial risk due to a change in leverage. In establishing Proposition II, Modigliani and Miller rely critically on an arbitrage process that forces the cost of equity to assume a value consistent with Proposition I. Although most of their analysis assumes constant debt rates, Modigliani and Miller allow that interest rates do vary with the level of leverage but that this variation does not affect the arbitrage process. In this paper, we argue that the arbitrage process is no longer dependable when debt rates change due to variation in leverage and discuss implications for teaching capital structure.

Deep Reinforcement Learning Based Real-Time Renewable Energy Bidding With Battery Control

Recently, various renewable energy sources and large-scale batteries have been integrated into power grids, and renewable energy bidding and battery control become critical problems in the real-time energy market. However, bidding and control problems have been studied separately while these two problems simultaneously influence the total profit of renewable producers. In this paper, we propose a novel strategy where renewable energy bidding and battery control are collectively investigated. First, unlike the previous studies where bidding is simply the forecasted value, the proposed methods determine the bidding values considering the error compensability of the battery by switching the objective of forecasting from reducing errors to making errors compensable. After the error compensation, additional battery control is applied to utilize the energy arbitrage process considering the energy price. As there are energy price and renewable generation uncertainties, we propose a deep reinforcement learning based bidding combined with control, called DeepBid, for sequential decision making under uncertainty. Our extensive simulations with real solar and wind generation data show that the proposed DeepBid strategy substantially increases the total profit compared to existing bidding strategies by achieving as high revenues as the arbitrage strategy and as low deviation penalties as the error compensation strategy.

Price Transmission Analysis of the International Soybean Market in a Trade War Context

This study analysed the dynamics of the international soybean market using econometric techniques and economic models to study the impacts of the US–China trade war. It considered the analysis of “spatial” (horizontal) price transmission during an approximately ten-year period from September 2009 to May 2019 using monthly time-series data. The research focused on the leaders in the international soybean market, namely, China, the USA, the EU, Brazil and Argentina. Several econometric techniques were employed. The stationarity of the price time series was determined using the augmented Dickey–Fuller (ADF) unit root test. Structural breaks were inferred using the ADF test with a breaks test and a Bai–Perron multiple break test. The long-term relation/cointegration amongst the series was determined using the Johansen cointegration test (1988), with the previous breaks input as dummy variables. The direction of the causality was inferred using the Granger causality test (1969). The long-term and short-term causal relations were determined using the vector autoregression model (VAR) and the vector error correction model (VECM). The results showed a highly efficient and cointegrated market. The incidents of the trade war, as represented by tariffs and subsidies, had minor effects on the market efficacy, cointegration and price transmission. The arbitrage process of the studied market managed to get around the tariffs. In other words, there was no empirical evidence to support the claim that the law of one price (LOOP) did not hold.

MARKET EFFICIENCY, FINANCIAL INTEGRATION, AND SHOCK TRANSMISSION (EMPIRICAL EVIDENCE FROM D-8 ECONOMIES)

The specific purpose of the Developing-8 economies is to integrate the endeavours of each member countries to excel economic cooperation and facilitation among the Islamic countries to enhance the investment opportunities and not to put pressure on the geopolitical environment of the world. The purpose of this study is to visualize the market efficiency, financial integration, and shock transmission process in the D-8 Economies for the period from Jan 2011 to Dec 2016. Daily market data is taken for KSE, DSE, TSE, JCI, KLCI, ISE, EGX, and NSE equity markets. Unit Root Test, Serial Correlation Test, Runs Test, and Variance Ratio Test are used to test the market efficiency whereas Johansen Cointegration Test, Granger Causality Test, Vector Error Correction Model, and Impulse Response Test are used to test the financial integration and shock transmission. The performance of the Tehran stock market remained excellent during this study period. Mixed evidence is concluded regarding the market efficiency of D-8 equity markets. It is concluded that there exists a long-run relationship between KSE and DSE. Short-run relationship indicates that KSE has a significant positive short-run relationship with JCI and have a negative relationship with KLCI. Negative asymmetric behaviour is more influential in the negatively skewed markets and negative shocks have a greater effect than the positive shocks. Hence it is concluded that investors can get benefit from the arbitrage process due to market inefficiencies and through the short selling process. There is a need to establish economic equilibrium through the arbitrage process where investors may enjoy the opportunities to excel more economic stream of benefits by noise and market reverting behaviour. The economic integration will increase the cooperation among these economies to establish more growth opportunities in the trade and corporate investments. The implication of the studies suggests and directs to enhance mutual interface and co-operation including Banking and Finance, Human and Social Development, Energy Sector, Development of Rural Population, Science and Technology, Health and Environment, and Agriculture Sector. Moreover, there is a dire need for restructuring the economic and financial bylaws that may ease the financial liberalization and to enhance the dynamics of trading actives among the D-8 economies.

When Anomalies Are Publicized Broadly, Do Institutions Trade Accordingly?

This paper studies whether institutional investors trade on 14 well documented stock market anomalies. We show that there is an increase in anomaly-based trading when information about the anomalies is readily available through academic publications and the release of necessary accounting data. This finding is more pronounced among hedge funds and institutions with high turnover, that is, the subset of investors who likely have the abilities and incentives to act on the anomalies. We directly relate the increase in trading to the observed decay in post-publication anomaly returns. Our results support the role of institutional investors in the arbitrage process and in improving market efficiency.This paper was accepted by Renée Adams, finance.

Does the law of one price hold for hedonic prices?

Hedonic prices of locational attributes in urban land markets are determined by a process of spatial arbitrage that is similar to that which underpins the law of one price. If hedonic prices deviate from their spatial equilibrium values then individuals can benefit from changing locations. I examine whether the law holds for the hedonic price of rail access using a unique historical dataset for Berlin over the period 1890–1914, characterised by massive investment in the transport infrastructure. I estimate the hedonic price of rail access across multiple urban neighbourhoods and time periods to generate a panel dataset of hedonic price differences that I test for stationarity using a panel unit root test. Across multiple specifications I consistently fail to reject the null hypothesis of no unit root and accept the alternative hypothesis that the law holds. My estimates indicate a half-life for convergence to the law of one price that lies between 0.28 and 1.14 years. This result is consistent with spatial equilibrium.

Option Pricing Under Short-Lived Arbitrage: Theory and Tests

Models in financial economics derived from no-arbitrage assumptions have found great favor among theoreticians and practitioners. We develop a model of option prices where arbitrage is short lived. The arbitrage process is Ornstein-Uhlenbeck with zero mean and rapid adjustment of deviations. We find that arbitrage correlated with the underlying can have sizeable impact on option prices. We use data from five large capitalization firms to test implications of the model. Consistent with the existence of arbitrage, we find that liquidity factors significantly effect arbitrage model parameters.

Option pricing under short-lived arbitrage: theory and tests

Models in financial economics derived from no-arbitrage assumptions have found great favour among theoreticians and practitioners. We develop a model of option prices where arbitrage is short lived. The arbitrage process is Ornstein–Uhlenbeck with zero mean and rapid adjustment of deviations. We find that arbitrage correlated with the underlying can have sizeable impact on option prices. We use data from five large capitalization firms to test implications of the model. Consistent with the existence of arbitrage, we find that idiosyncratic factors significantly effect arbitrage model parameters.

Futures Arbitrage of Different Varieties and based on the Cointegration Which is under the Framework of Bayesian—In the Case of Soy Oil and Palm Oil

This paper mainly studies commodity futures arbitrage opportunities across the soy oil and palm oil. The traditional way is traders can carry into the market when the spread out of the reasonable scope. When the price back to normal levels, unwinding operation and complete an arbitrage process. However, spreads of soy oil and palm oil does not meet the stability, so we need to test cointegration model residual error after regression, combined with the maximization of expected return to determine the arbitrage opportunity. In traditional cointegration model, long-term equilibrium relationship is t t y = 3070.8 + 0.50x . When the residual absolute value is greater than 61.125, arbitrageurs may take positions into the market, until the residual back to a reasonable range. However the traditional cointegration model without considering the estimation error, and estimated parameter has high sensitivity. So we will use the bayesian method to estimate parameters, we get the Bayesian- cointegration is t t y = 3071+ 0.54x . The residual under this model is stable. Therefore, we can find arbitrage opportunities through the model. When the residual is more than 142.475 or less than-126.475 triggered buying conditions, and can gain maximum expected return.

Noise Momentum Around the World

We argue that arbitrageurs will strategically limit their initial investment in an arbitrage opportunity in anticipation of further mispricing caused by the deepening of noise traders' misperceptions. Such ‘noise momentum’ is an important determinant of the overall arbitrage process. We design an empirical strategy to capture noise momentum in a two‐period generalized error correction model. Applying it to a wide range of international spot‐futures market pairs, we document pervasive evidence of noise momentum around the world.

Testing the Weak Form of Efficient Market Hypothesis: Empirical Evidence from Asia-Pacific Markets

This empirical study is conducted to test the weak-form market efficiency of the stock market returns of Pakistan, India, Sri Lanka, China, Korea, Hong Kong, Indonesia, Malaysia, Philippine, Singapore, Thailand, Taiwan, Japan and Australia. Monthly observations are taken for the period January 2004 to December 2009. Autocorrelation, Ljung-Box Q-statistic Test, Runs Test, Unit Root Test and the Variance Ratio are used to test the hypothesis that the stock market follows a random walk. Monthly returns are not normally distributed, because they are negatively skewed and leptokurtic. In aggregate we concluded that the monthly prices do not follows random walks in all the countries of the Asian-Pacific region. The investors can take the stream of benefits through arbitrage process from profitable opportunities across these markets.

The Limits of Arbitrage and Stock Mispricing: Evidence from Decomposing the Market to Book Ratio

The purpose of this paper is to investigate the effect of the of on securities mispricing. Specifically, I investigate the effect of the availability of substitutes and financial constraints on stock mispricing. In addition, this study investigates the difference in the limits of arbitrage, in the sense that it will lead to lower mispricing for these stocks, relative to non-S&P 500 stocks. I also examine if the lower mispricing can be attributed to their lower limits of arbitrage. Modern finance theory and efficient market hypothesis suggest that security prices, at equilibrium, should reflect their fundamental value. If the market price deviates from the intrinsic value, then a risk-free profit opportunity has emerged and arbitrageurs will eliminate mispricing and equilibrium is restored. This arbitrage process is characterized by large number of arbitrageurs which have infinite access to capital. However, a better description of reality is that there are few numbers of arbitrageurs to the extent that they are highly specialized; and they have limited access to capital. Under these condition arbitrage is no more a risk-free activity and can be limited by several factors such as arbitrage risk and transaction costs. Other factors that are discussed in the literature are availability of substitutes and financial constraints. The former arises as a result of the specialization of arbitrageurs in the market in which they operate, while the latter arises as a result of the separation between arbitrageurs and capital. In this dissertation, I develop a measure of the availability of substitutes that is based on the propensity scores obtained from propensity score matching technique. In addition, I use the absolute value of skewness of returns as a proxy of financial constraints. Previous studies used the limits of arbitrage framework to explain pricing puzzles such as the closed-end fund discounts. However, closed-end fund discounts are highly affected by uncertainty of managerial ability and agency problems. This study overcomes this problem by studying the effect of limits of arbitrage on publicly traded securities. The results show that there is a significant relationship between proxies of limits of arbitrage and firm specific mispricing. More importantly, empirical results indicate that stocks that have no close substitutes have higher mispricing. In addition, stocks that have high skewness show higher mispricing. Subsequent studies show that the S&P 500 stocks have different levels of liquidity, analysts’ coverage and volatility. These characteristics affect the ability of arbitrageurs to eliminate mispricing. Preliminary univariate tests show that S&P 500 stocks have, on average, lower mispricing and limits of arbitrage relative to non-S&P 500 stocks. In addition, the multivariate test shows that S&P 500 members have, on average, lower mispricing relative to non-S&P 500 stocks.

Institutional Trading and Anomalies

We study whether institutional investors trade on stock market anomalies. We condition our analysis on whether information about the anomalies is readily available to investors through academic publication and the release of necessary accounting data. Using 14 well-documented anomalies, we observe an increase in anomaly-based trading among institutional investors, especially hedge funds and transient institutions, following the publication of research on anomalies. We directly relate this increase in trading to the observed decay in post-publication anomaly returns. In contrast to recent evidence, our findings support the role of institutional investors in the arbitrage process and in improving market efficiency.

Statistical Arbitrage: Profits through Pairs Trading

Statistical arbitrage is a popular device among hedge fund managers and assets management professionals. It refers to simultaneous buying and selling two different capital assets to earn super-normal profit. By identifying persistent anomalies that violate the efficient market hypothesis, statistical methods can be used to create a trading strategy to generate profit with high probability. A pair trading is one such trading strategy which is based on statistical arbitrage process. Pairs trading can be simple in concept, but can be one of the most complex types of trading in practice. The starting point of this strategy is that stocks that have historically had the same trading patters will have so in future as well. If there is a deviation from the historical mean this creates a trading opportunity, which can be exploited. Gains are earned when the price relationship is resorted. The basic premise of this strategy is that stock prices follow a mean reverting process. The objective of this paper is to identify arbitrage opportunities and calculating profits earned through these opportunities by using statistical tools.
 Many questions need to be answered before one can implement such strategy viz. which pair of stocks should be traded, how much do we buy/sell of each stock, how to catch the signal of an opportunity (i.e opening a position) and when to close the position so that profit could be earned. In this paper we have taken daily closing prices from 1/1/2010 to 1/1/2011 of thirty scrips of BSE-Sensex to form pairs. Pairs are formed on the basis of minimum distances between two stocks. We have decided not to invest anything. That is, purchase the same rupee amount of the long stock as we sell of the short stock so that strategy is self-financing. We open a position when the absolute value of the difference gets larger than two of its historical standardization. To unwind the position, we wait until the first time it crosses zero. To calculate the profit/loss of this strategy, we have used “R-Software”. It is observed that profit could be earned through pairs trading if it is applied without losing patience. By identifying persistent anomalies that violate the efficient market hypothesis, statistical methods can be used to create a trading strategy to generate profit with high probability.

The solvency of financial institutions in Spain: lessons from securitization

On analysing a sample of Spanish banks, we find that securitization has a slightly negative impact on the soundness of the issuing entity. An unbalanced dynamic panel model was estimated using the forward orthogonal deviations GMM method and used to analyse 537 traditional securitizations issued by 61 banks between 1998 and 2012. The analysis revealed that the entities’ soundness became weaker immediately prior to the crisis, but this effect became insignificant after 2007. Securitization has facilitated a process of regulatory capital arbitrage leading to lower capital requirements while, at the same time, giving rise to a slight worsening of the quality of the originators’ portfolios. It was found that profitability, liquidity and inflation positively affect solvency, while changes in short-term interest rates affect it negatively.

The Decision to Produce Altcoins: Miners' Arbitrage in Cryptocurrency Markets

Bitcoin has become the de facto 'gold' standard among cryptocurrencies as it is the most widely accepted in commerce, has the largest mining network, and greatest volume of transactions. Because of this, miners of other SHA-256 cryptocurrencies will tend to convert those altcoins into bitcoin in order to transact in a meaningful way with the real economy. The result is that bitcoin mining regulates that of all other SHA-256 blockchains. Specifically, what matters is the expected number of bitcoins produced per day given a unit of hashing (mining) power, whatever the equivalence in the coin being mined. If mining for a different coin would yield a greater return in bitcoins at the margin (per day) for a miner, an apparent arbitrage opportunity will exist to direct mining effort at that cryptocurrency and subsequently exchange those for bitcoin. These opportunities, once taken, quickly eliminate the profitable arbitrage and appear to operate in a fairly efficient and predictable manner. A model is developed in this paper to formalize this process where cryptocurrency miners seeking to maximize production in terms of bitcoins earned in a day will exploit any such opportunities. If no such opportunities exist, they will simply revert to mining bitcoins directly. There are some important implications to this process, such as a tendency for cryptocurrencies to fall in price relative to bitcoin over time, and for changes in bitcoin mining difficulty to indirectly influence the market prices of altcoins. Finally, it seems that those undertaking this process of miners' arbitrage do so at the expense of speculators and noise traders who make decisions regarding buy and sell trades without the use of fundamental data. These participants generally have poor timing, follow trends, and over-react to good and bad news. Altcoins are produced by miners and subsequently offered for sale in the market in order to obtain bitcoins; meanwhile noise traders serve as the only bid-side to the market, on average.

Fact and fictions in FX arbitrage processes

The efficient markets hypothesis implies that arbitrage opportunities in markets such as those for foreign exchange (FX) would be, at most, short-lived. The present paper surveys the fragmented nature of FX markets, revealing that information in these markets is also likely to be fragmented. The "quant" workforce in the hedge fund featured in The Fear Index novel by Robert Harris would have little or no reason for their existence in an EMH world. The four currency combinatorial analysis of arbitrage sequences contained in [1] is then considered. Their results suggest that arbitrage processes, rather than being self-extinguishing, tend to be periodic in nature. This helps explain the fact that arbitrage dealing tends to be endemic in FX markets.

Overreacting to a History of Underreaction?

Prior research has documented that arbitrage activity significantly reduces or eliminates stock market anomalies. However, if anomalies arise due to unsophisticated investors’ behavioral biases, then these same biases can also apply to unsophisticated arbitrageurs and thereby disrupt the arbitrage process. Consistent with a disruption in the arbitrage process for the post-earnings announcement drift anomaly, I document that the historically positive autocorrelation in firms’ earnings announcement news has become significantly negative for firms with active exchange-traded options. For these easy-to-arbitrage firms, the firms in the highest decile of prior earnings announcement abnormal return (prior earnings surprise), on average, underperform the firms in the lowest decile by 1.59% (1.43%) at their next earnings announcement. Additional analyses are consistent with investors learning about the post-earnings announcement drift anomaly and overcompensating. This study suggests that unsophisticated attempts to profit from a well-known anomaly can significantly reverse a previously documented stock return pattern.

Unsophisticated Arbitrageurs and Market Efficiency: Overreacting to a History of Underreaction?

ABSTRACTPrior research has documented that arbitrage activity significantly reduces or eliminates stock market anomalies. However, if anomalies arise due to unsophisticated investors’ behavioral biases, then these same biases can also apply to unsophisticated arbitrageurs and thereby disrupt the arbitrage process. Consistent with a disruption in the arbitrage process for the post‐earnings announcement drift anomaly, I document that the historically positive autocorrelation in firms’ earnings announcement news has become significantly negative for firms with active exchange‐traded options. For these easy‐to‐arbitrage firms, the firms in the highest decile of prior earnings announcement abnormal return (prior earnings surprise), on average, underperform the firms in the lowest decile by 1.59% (1.43%) at their next earnings announcement. Additional analyses are consistent with investors learning about the post‐earnings announcement drift anomaly and overcompensating. This study suggests that unsophisticated attempts to profit from a well‐known anomaly can significantly reverse a previously documented stock return pattern.

Pricing American options when there is short-lived arbitrage

Models in financial economics derived from no–arbitrage assumptions are standard fare among theoreticians and practitioners. However, several authors have investigated the impact of short lived arbitrage on European options using models borrowed from disequilibria in physics. In this paper, we extend that research by assessing the impact of arbitrage on American options. We use an Ornstein–Uhlenbeck Bridge as a model for the arbitrage process and calculate American option prices using a bivariate lattice with density matched probabilities. We find that arbitrage correlated with the underlying has an economically meaningful sizeable impact on option prices. Short lived arbitrage has essentially virtually no economic impact on option prices when the arbitrage is uncorrelated with underlying asset returns.