Profitable Arbitrage Opportunities Research Articles

A New Test of Statistical Arbitrage with Applications to Credit Derivatives Markets

This paper presents a new statistical arbitrage test which has lower Type I error and selects arbitrage opportunities with lower downside risk than existing alternatives. The test is applied to credit derivatives markets using strategies combining Credit Default Swaps (CDS) and Asset Swaps. Using four different databases (GFI, Reuters, CMA and JP Morgan) from 2005 to 2009, we find persistent mispricings between the CDS and Asset Swap spreads before and during the current financial crisis. These mispricings appear to offer arbitrage opportunities if a standard statistical arbitrage test is employed. However, our test shows that after considering funding and trading costs, these mispricings are unlikely to provide profitable arbitrage opportunities.

Inefficiency in deregulated wholesale electricity markets: the case of the New England ISO

The efficiency of the New England Independent System Operator electricity market is examined. Using peak hour prices from March 2003 to February 2007, significant differences between Day Ahead (DA) and spot prices are found, indicating that profitable arbitrage opportunities existed in the DA market. It is also found that persistence of price volatility is higher in the DA market, indicating that information is not incorporated into DA prices as quickly as it is in the spot market.

An empirical investigation of the informational efficiency of the GCC equity markets: Evidence from bootstrap simulation

The aim of this study is to explore whether the Gulf Cooperation Council (GCC) equity markets are informationally efficient with regard to oil and gold price shocks during the period 2006–2008 using daily dollar-based stock market indexes dataset. This paper extends research literature related to the assessment of market efficiency in emerging markets by providing a robust bootstrap simulation technique for the entire GCC financial markets. Unlike most empirical studies in this field, this study represents the first known attempt in empirically examining the impact of oil and gold prices on the financial performance of the six distinctive GCC stock markets. Tests for non-normality and ARCH effects show that the selected variables are not normally distributed and the volatility is time varying. This implies that the standard econometric methods are not reliable to carry out a trustworthy testing of market efficiency. To this end, we use a new method and testing technique which is robust to both non-normality and ARCH effects. The empirical findings reveal that the GCC equity markets are informationally efficient with regard to gold and oil price indexes. Our results entail that short-term arbitrage profit opportunities in the equity markets of these countries might not prevail. Moreover, our findings can reconcile previously contradictory results regarding the weak and semi-strong forms of efficiency of the GCC stock markets and its relation vis-à-vis petrol and gold prices. These findings have important policy implications and should be of interest to market participants, researchers, regulators and policymakers. The results of this paper also provide an incentive for further research in the areas of emerging market efficiency, strategic asset allocation, and portfolio risk management.

Stock prices and the efficient market hypothesis: Evidence from a panel stationary test with structural breaks

This paper investigates whether the efficient market hypothesis holds in stock markets under different economic development levels over the period January 1999 to May 2007. We employ a state-of-the-art panel data stationarity test which incorporates multiple structural breaks. Evidence indicates that when accommodating general forms of cross-sectional dependence as well as controlling for finite-sample bias, the real stock price series appear to be stationary in 32 developed and 26 developing countries, respectively, which is in sharp contrast to the findings in the existing literature. Thus, real stock price indices are stationary processes that are inconsistent with the efficient market hypothesis. This shows the presence of profitable arbitrage opportunities among stock markets. According to these estimated structural breakpoints, we are also able to discover the reason for why there has been a huge impact from past stock prices.

How efficient is the European football betting market? Evidence from arbitrage and trading strategies

AbstractThis paper assesses the international efficiency of the European football betting market by examining the forecastability of match outcomes on the basis of the information contained in different sets of online and fixed odds quoted by six major bookmakers. The paper also investigates the profitability of strategies based on: combined betting, simple heuristic rules, regression models and prediction encompassing. The empirical results show that combined betting across different bookmakers can lead to limited but highly profitable arbitrage opportunities. Simple trading rules and betting strategies based on forecast encompassing are found capable of also producing significant positive returns. Despite the deregulation, globalization and increased competition in the betting industry over recent years, the predictabilities and profits reported in this paper are not fully consistent with weak‐form market efficiency. Copyright © 2008 John Wiley & Sons, Ltd.

Energy prices, multiple structural breaks, and efficient market hypothesis

This paper investigates the efficient market hypothesis using total energy price and four kinds of various disaggregated energy prices – coal, oil, gas, and electricity – for OECD countries over the period 1978–2006. We employ a highly flexible panel data stationarity test of Carrion-i-Silvestre et al. [Carrion-i-Silvestre JL, Del Barrio-Castro T, Lopez-Bazo E. Breaking the panels: an application to GDP per capita. J Econometrics 2005;8:159–75], which incorporates multiple shifts in level and slope, thereby controlling for cross-sectional dependence through bootstrap methods. Overwhelming evidence in favor of the broken stationarity hypothesis is found, implying that energy prices are not characterized by an efficient market. Thus, it shows the presence of profitable arbitrage opportunities among energy prices. The estimated breaks are meaningful and coincide with the most critical events which affected the energy prices.

Cross‐market efficiency in the Indian derivatives market: A test of put–call parity

AbstractThis study examines the cross‐market efficiency of the Indian options and futures market using model‐free tests. The put–call–futures and put–call–index parity conditions are tested for European style Nifty Index options. Thirty‐five‐month time‐stamped transactions data are used to identify mispricing. Frequent violations of both forms of put–call parity are observed. The restriction on short sales largely accounts for the put–call–index parity violations. There are numerous put–call–futures arbitrage profit opportunities even after accounting for transaction costs, which vanish quickly. Put options are overpriced more often than call options. The mispricing shows specific patterns with respect to time of the day, moneyness, volatility, and days to expiry. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:889–910, 2008

American futures options arbitrage: evidence from the Nikkei 225 options market

Previous studies have examined the profitability of European index options arbitrage. This paper adds to the literature by investigating the arbitrage profitability of American index options—the Nikkei 225 index futures options traded on the Singapore Stock Exchange (SGX). Using the real-time bid–ask prices, we find evidence of profitable arbitrage opportunities, while the frequency of observations violating no-arbitrage bounds and the magnitude of arbitrage profits decrease with the level of transaction costs. Our results have implications for the analysis of American options market efficiency. Failure to use bid–ask prices may lead to biased conclusions.

Empirical investigation of stock index futures market efficiency: the case of the Athens Derivatives Exchange

Pricing and trading practices in the Athens Derivatives Exchange, a newly established derivatives market, result in significant futures arbitrage profit opportunities for low-cost traders. We find that a large part of the mispricing is due to transaction costs, but additional factors, such as anticipated volatility and time to maturity, also contribute. Ex ante tests reveal significant arbitrage opportunities that could have been exploited up to 30 min after they had been identified. All different tests employed indicate that the derivatives market was inefficient during its early trading history because arbitrage opportunities persisted even after other market impact costs were taken into consideration.

How Efficient is the European Football Betting Market? Evidence from Arbitrage and Trading Strategies

This paper assesses the international efficiency of the European football betting market by examining the forecastability of match outcomes on the basis of the information contained in online and fixed odds quoted by six major bookmakers. The paper also investigates the profitability of strategies based on: combined betting, simple heuristic rules, regression models and prediction encompassing. The empirical results show that combined betting across different bookmakers can lead to limited but highly profitable arbitrage opportunities. Simple trading rules and betting strategies based on forecast encompassing are found capable of also producing significant positive returns. Despite the deregulation, globalization and increased competition in the betting industry over recent years, these predictabilities and profits are not fully consistent with weak-form market efficiency.

Box Spread Strategies and Arbitrage Opportunities

Arbitrage, or more precisely, absence of arbitrage opportunities, is at the heart of derivatives theory, and the literature abounds with empirical studies of arbitrage strategies. Some model-based arbitrage trades are straightforward, like the cash-and-carry trade in futures; others are harder, like option replication through dynamic hedging; and some represent a kind of “notional” arbitrage that may not be possible at all in practice, like most of those covered by the “absence of arbitrage opportunities” assumption in an option model with unobservable latent factors. In empirical tests of arbitrage strategies, as in so many other things, “the devil is in the details.” There are many ways in which a seemingly reasonable test methodology can fail to reflect important aspects of the actual trades that would have to be executed in real world arbitrage. Was all of the necessary information available at the time of the trade? Were price quotes on all of the instruments simultaneous? After price quotes are observed, does the methodology allow an adequate reaction time interval before trades are assumed to be executed? What quantity could have been traded at the specified prices? Would the profit have been eliminated by normal transactions costs? And so on. Handling these issues properly places severe demands on the data-gathering process. In the end, very, very few empirical tests of arbitrage strategies can fully capture the reality of the actual trade. But this article by Benzion, Danan, and Yagil does. The authors have done everything right, from their choice of the box spread arbitrage strategy, which is both very low risk and internally hedged without any need for rebalancing, to installing a specialized computer program on a broker9s computer to look for trades in real time, to taking care that the same mispriced option is not assumed to be simultaneously part of multiple “arbitrage opportunities.” The bottom line: there are quite a few profitable arbitrage opportunities on the Tel Aviv stock exchange—so long as one can detect them and execute the necessary trades within one second

Nonlinear dynamics and covered interest rate parity

This paper examines the dynamics of deviations from covered interest parity using daily data on the UK/US spot, forward exchange rates and interest rates over the period January 1974 to September 1993. Like other studies we find a substantial number of instances during the sample in which the covered interest parity condition exceeds the transaction costs band, implying arbitrage profit opportunities. While most of these implied profit opportunities are relatively small, there is also evidence of some very large deviations from covered interest parity in the sample. In order to examine the persistence of these deviations, we estimated a threshold autoregression in which the dynamics behavior of deviations from covered interest parity is different outside the transaction costs band than inside them. We find that while the impulse response functions when inside the transaction costs band are nearly symmetric, those for the outside the bands are asymmetric-suggesting less persistence outside of the transaction costs band than inside the band.

Nonlinear dynamics and covered interest rate parity

This paper examines the dynamics of deviations from covered interest parity using daily data on the UK/US spot, forward exchange rates and interest rates over the period January 1974 to September 1993. Like other studies we find a substantial number of instances during the sample in which the covered interest parity condition exceeds the transaction costs band, implying arbitrage profit opportunities. While most of these implied profit opportunities are relatively small, there is also evidence of some very large deviations from covered interest parity in the sample. In order to examine the persistence of these deviations, we estimated a threshold autoregression in which the dynamics behavior of deviations from covered interest parity is different outside the transaction costs band than inside them. We find that while the impulse response functions when inside the transaction costs band are nearly symmetric, those for the outside the bands are asymmetric-suggesting less persistence outside of the transaction costs band than inside the band.

Matching the moments: a test of three representative agent models

No arbitrage profit opportunities implies state-contingent shadow prices that value the state-contingent payoffs of any asset traded in perfect markets. The shadow price is an implicit stochastic discount factor. I decompose the implicit model free nominal discount factor into its observable conditional mean—the price of a default free discount bond—and an unobservable innovation. I infer the unconditional covariance matrix between innovations in the model free discount factor and returns. Dynamic behavioural economic models specify, or imply, a discount factor. The theoretical mean of the nominal model generated discount factor is the observable price of a default free discount bond. A necessary condition for any model to be consistent with securities market data is that the moments of the deviations of the model-generated discount factor from its theoretical conditional mean (call the deviations residuals) match the moments of innovations in the model free discount factor. This is an easy specification test for any model. I match the moments for three representative agent specifications—power utility, habit formation, and a consumption-leisure choice model. The moments from the more complicated specifications come closer to matching the model free moments, but none of the representative agent models generates a covariance (risk premium) large enough to match the model free covariance

The Grain Trade in Contemporary Canada-U.S. Relations

Background Canada and the United States share the largest trading relationship between two sovereign nations that has ever existed. Much of current volume in trade has been the result of the tremendous growth subsequent to the 1989 Canada-U.S. Free Trade Agreement (CUFTA). Despite these very large commercial ties across many sectors, and the existence of NAFTA and World Trade Organization (WTO) agreements that outline rules for trade, trade in the grain sector has, nonetheless, been a frequent source of disputes. Increased grain exports from Western Canada into the U.S. have led to numerous disputes in which the U.S. government has legally challenged this Canadian access to its market. This paper analyzes the economic and legal factors that have contributed to these recent grain trade disputes and, further, it speculates as to whether these factors will continue to create pressure for grain disputes. To these ends, it will begin with a brief review of the recent changes in the legal framework for Canada-U.S. trade as a result of CUFTA, NAFTA, and WTO trade agreements, and a description of some of the visible changes in the marketplace, including changes in the grain trade flows that have occurred in the last decade through the merger of firms. This will be followed by an analysis of the economic forces that have affected the Canada-United States grain trade and a description of some of the concerns of the U.S. industry with respect to grain exports from Canada. The final section of the paper contains our assessment of the likelihood of future grain trade disputes. For many years there were significant barriers to trade in grains between Canada and the United States. Canada protected its domestic market for wheat, oats, and barley with the use of import licenses administered by the Canadian Wheat Board (CWB). This protection allowed the CWB to operate the two-price policy, where CWB sales to domestic processors were generally maintained well above world prices. Until 1989, the United States had an import tariff of $0.21 per bushel ($8/t) on grain and canola that had not obtained GRAS (generally regarded as safe for human food consumption) status from the U.S. Food and Drug Administration (U.S. International Trade Commission). These measures virtually eliminated profitable arbitrage opportunities for Canada-U.S. grain trade. In January 1989, the Canada-U.S. Free Trade Agreement made a new attempt to integrate the North American grain market. It contained a formula to allow for removal of the Canadian import licenses and the U.S. import tariff on grains, eliminated export subsidies between the two grain markets, reduced Canada's grain transportation subsidy to some U.S. destinations, and obliged the Canadian Wheat Board (CWB) not to sell grain into the U.S. below cost. The most noteworthy aspect of CUFTA was that, for the first time, an international legal institution was created for the resolution of trade disputes between Canada and the U.S.: the Chapter 18 Binational Panel system. This new element of the legal trade framework was soon tested in the durum case we will turn to presently, but the system functioned effectively to bring a rules-based solution to a trade irritant. The application of the rule of law in an international setting, where power politics previously determined the outcome, was a welcome development for trade liberalization. Since the agreement came into force, the United States has imported significant amounts of bread wheat, durum wheat, feed wheat, barley, oats, canola, and flaxseed. As shown in Figure 1, Canadian grain exports to the United States have risen steadily to exceed four million tonnes in the 1996-97 crop year. What is most striking about the number is that both CWB grains (wheat and barley) and non-CWB grains (oats, canola, and flaxseed) have increased significantly since the CUFTA. The domestic sale of milling wheat, durum, and malting barley in Canada and the U. …

Are liquidity and corporate control priced by shareholders? Empirical evidence from Swiss dual class shares

Stadard asset pricing models generally exclude corporate control and liquidity considerations as joint explanatory factors of the stock price formation process. This empirical study investigates their influence on Swiss Bearer and Registered share prices issued by the same firm. It is shown that the statistical properties of both shares' returns differ without implying profitable arbitrage opportunities. A multifactor model of the ‘premium’ between Bearer and Registered stock prices is then proposed and tested. The results show that the freely negotiable equity book value, the existence of dominant shareholder positions and ownership transfer regime changes are significant variables in explaining the dual class share price differential.

Price discovery in the Hong Kong security markets: evidence from cointegration tests

Abstract According to the theory of efficient markets, price adjustments occur so rapidly that profitable arbitrage opportunities cannot exist among risk-adjusted price differentials across individual securities as well as different submarkets (industries). That is, observed prices represent long-run equilibrium prices among different submarkets given certain types of risk-return relationships. By performing cointegration tests and estimating an error correction model, this study finds evidence that a stable long-run linear relationship exists among four security submarkets in Hong Kong. The results of the error correction model not only indicate the significant increase in explanatory power of the model compared with the vector autoregressive (VAR) model, but also suggest that price changes in one submarket have significant impacts on other three submarkets. In addition, the explicit process of price discovery among four submarkets in Hong Kong is implied in the coefficients for error correction terms.

Arbitrageur Heterogeneity, Investor Horizon and Arbitrage Opportunities: An Empirical Investigation

AbstractEvidence is provided that arbitrage profits in integrated currency and credit markets differ according to the initial asset allocation, trading horizon and investment objectives of arbitrageurs. It is shown that several types of profitable one‐way strategies can coexist and profits are differently distributed across maturity horizons. Moreover, there are episodes in the markets where particular strategies are consistently profitable. Strategies using the spot market and two credit transactions to create a synthetic forward contract are most likely to result in profitable arbitrage opportunities. This is directly attributable to the higher level of transactions costs in the forward markets.

Purchasing power parity yet again: evidence from spatially separated commodity markets

this paper examines the empirical validity of the law of one price by exploiting the non-stationarity of prices, set in US dollars, of varieties of wheat that are traded simultaneously in the USA, Rotterdam and Japan. We demonstrate the crucial role of transport costs in achieving cointegration (long-run PPP). Although systematic short-run deviations from PPP occur, we show that this does not imply profitable arbitrage opportunities. (JEL C5, F3, G1).

Stock market efficiency the evidence from FTA indices of eleven major stock markets

This article presents a survey of recent literature on stock market efficiency, with special reference to the US and Dutch stock markets. Additionally, models are specified and estimated for the daily return since 1987 on FTA indices for eleven major stock markets, allowing for non-normality, heteroskedasticity, leverage effects and autocorrelation. The leverage effect and positive autocorrelation are characteristics of some of the indices investigated. The magnitude of the autocorrelation, however, is so small, that no profitable arbitrage opportunities arise and weak-form efficiency of these stock markets is not rejected.