Arbitrage Risk Research Articles

Stochastic Arbitrage Opportunities for Stock Index Options

To analyze the economic significance of pricing errors of stock index options, a system of linear inequalities is developed which completely characterizes all risk arbitrage opportunities which arise if a well-behaved pricing kernel does not exist. The Stochastic Arbitrage system can account for market imperfections in the form of transactions costs and general portfolio restrictions. An active trading strategy based on the Stochastic Arbitrage system for front-month S&P500 stock index options yields significant abnormal returns out of sample, for small-scale portfolios. However, outperformance seems elusive if the strategy is scaled up and market depth is taken into account.

Do Limits to Arbitrage Explain the Benefits of Volatility-Managed Portfolios?

We investigate whether transaction costs, arbitrage risk, and short-sale constraints explain the abnormal returns of volatility-managed equity portfolios. Even using five cost-mitigation strategies, after accounting for transaction costs, volatility management of common asset-pricing factors besides the market return generally produces zero abnormal returns and significantly reduces Sharpe ratios. In contrast, abnormal returns of the volatility-managed market portfolio are profitable after transaction costs and concentrated in the most easily arbitraged stocks, those with low arbitrage risk and short-sale constraints. Moreover, the managed-market strategy only provides superior performance when sentiment is high, consistent with prior theory that sentiment traders under-react to volatility.

ESMA issues Brexit opinions to EU regulators: a warning shot not only to the UK but also to the EU27

PurposeTo summarize and analyse four opinions issued in May and July 2017 by the European Securities and Markets Authority (“ESMA”) concerning regulatory and supervisory arbitrage risks that arise as a result of increased requests from financial market participants to relocate activities and functions in the EU27 following the UK’s decision to withdraw from the EU, and the expected regulatory response to those risks.Design/methodology/approachDiscusses the possible relocation of financial firms, activities and functions following the UK’s decision to withdraw from EU; the resulting cross-sectoral regulatory and supervisory arbitrage risks that ESMA foresees; nine principles that ESMA enumerates to guide its regulatory response to those risks; some common themes that emerge from ESMA’s July Opinions; and the implications for UK firms and trading venues seeking to establish a presence in the EU 27.FindingsESMA foresees regulatory and arbitrage risks in Brexit and a potential “race to the bottom” as certain national regulators jostle for and grab UK market share.Practical implicationsUK firms and trading venues seeking to establish a presence in the EU27 from which to operate will need to give detailed consideration and focus to the resources and operational substance which will need to be located in the jurisdiction in which that presence is established.Originality/valuePractical guidance from experienced financial services, securities and fund management lawyers.

How Pervasive and Investable is the Asset Growth Anomaly?

Based on U.S. stock returns from 1973 to 2015, this study found that the asset growth anomaly does not seem to be pervasive and investable. The trading strategy is robust only among a tiny portion of the equity market in terms of both number of stocks and capitalization. In addition to underdiversifcation and capacity constraint, the implementation also involves high arbitrage risk, illiquidity and price impact, low stock loan supply, and potentially non-negligible brokerage fee.

A Proposed Risk Modeling Shift from the Approach of Stochastic Differential Equation towards Machine Learning Clustering: Illustration with the Concepts of Anticipative & Responsible VaR

The aim of this technical document is threefold with the bigger picture being to contribute, within the challenging regulatory environment, to bring closer together traditional conflicting practices such as trading vs risk as well as risk responsiveness vs stability. In order to achieve this goal, we first expose some of the complexity associated to the risk factors and arbitrage constraints associated with the options and the high frequency markets by re-introducing the Implied Volatility Parametrization (IVP), and the High Frequency Trading Ecosystem (HFTE). The exposed complexity is then contrasted with the current obsolete Risk Methodologies which are based on simplistic SDEs which we extent using the Cointelation model in order to partially address some of the complexity introduced by the challenging regulatory environment such as scenario coherence. We then present a simple Machine Learning clustering methodology which is designed to address and mirror the enhancements of these SDEs in a simpler fashion. We illustrate our findings by introducing few new risk concepts such as the Anticipatible VaR which aims at being a leading as opposed to a lagging (Responsive) risk measure to a market regime change.

Open-End Organizational Structures and Limits to Arbitrage

We provide evidence that open-end organizational structures undermine incentives for asset managers to attack long-term mispricing. We compare open-end funds with closed-end funds. Closed-end funds purchase more underpriced stocks than do open-end funds, especially if the stocks involve high arbitrage risk. We then show that hedge funds with highshare restrictions having a lower degree of open-endedness also trade against long-term mispricing to a larger extentthan do other hedge funds. Our analysis suggests that open-end organizational structures are not conducive to long-term risky arbitrage. Received November 4, 2015; editorial decision March 10, 2017 by Editor Andrew Karolyi.

An Empirical Investigation on Spot and Futures Market With Reference to Energy Sector on NSE

The importance of volatility is widespread in the area of financial economics. Equilibrium prices, obtained from asset pricing models, are affected by changes in volatility, investment management lies upon the mean-variance theory, while derivatives valuation hinges upon reliable volatility forecasts. Portfolio managers, risk arbitrageurs, and corporate treasurers closely watch volatility trends, as changes in prices could have a major impact on their investment and risk management decisions. Volatility may be defined as the degree to which asset prices tend to fluctuate. Volatility is the variability or randomness of asset prices. Volatility is often described as the rate and magnitude of changes in prices and in finance often referred to as risk. This study has been carried out on Spot and Futures market with reference to energy sector stocks on NSE. It also analysed the co-integration and Causal relationship between Spot and Futures prices of stocks and index. The study also estimated the impact of Spot market on Futures market. The study has been carried out on volatility of Indian Stock Market represented by S&P CNX Nifty Index along with influence by energy sector stocks.

Differences in Expectations and the Cross Section of Stock Returns

We provide strong evidence that differences in expectations (DiE) among options investors, measured from the dispersion of equity options trading volume across moneyness levels, contain valuable information about future stock returns. Stocks with high DiE consistently underperform on average those with low DiE by more than 1% per month, with the negative DiE-return relationship strongest when short-sale constraints are high and among stocks that exhibit relatively high arbitrage risk. Moreover, we document that the DiE effect is highly persistent, pronounced in high sentiment periods, and is robustly distinct from a large array of previously documented cross-sectional return predictors.

Investor Disagreement and Merger Outcomes

This paper examines how a target firm's trading volume, bid-ask spread, and stock return volatility respond over a two-week period to the announcement of M&A deals (nonprice reactions). I find that these variables are strongly correlated with changes in risk arbitrageurs' holdings surrounding the time of an announcement, whose ability to predict deal outcomes is often argued to be superior to that of other investors. I show that nonprice reactions predict deals that are more likely to be renegotiated, to feature slower completion times, and to fail even after controlling for merger arbitrage spreads and announcement returns. A trading strategy that involves investing in target firms with a low degree of failure risk, as predicted by nonprice reactions, yields positive abnormal returns. The presented results suggest that a target firm's volume, spread, and volatility after an M&A announcement reflect information about a deal's resolution not fully incorporated into stock prices and cast doubt on the notion that arbitrage spreads represent a deal's risk of failure as perceived by investors.

Decomposing the Value Premium: The Role of Intangible Information in the Chinese Stock Market

Compared with other developed stock markets, the Chinese stock market has a unique informational and trading environment. Given this unique environment, we find that intangible information (which is orthogonal to past accounting information) and arbitrage risk are potential sources of the value premium. In particular, our single and multivariate decomposition analyses suggest that intangible information directly contributes at least 40% to the value premium over a one-year investment horizon. Further, idiosyncratic volatility, a proxy for arbitrage risk, also influences the value premium. However, its contribution becomes insignificant once we account for the impact of intangible information on idiosyncratic volatility. Overall, our findings indicate that intangible information, which is unrelated to the firm’s “fundamental” accounting-based performance measures, is the key driver of the value effects in the Chinese stock market.

Risk arbitrage in emerging Europe: are cross-border mergers and acquisition deals more risky?

Speculation spread in mergers and acquisitions (M&A), measured as the percentage difference between the offer price and the closing stock price of a target the day after the announcement, is the starting point for risk arbitrage returns, a topic receiving greater consideration both in practice and in the empirical literature. Reflecting the degree of risk in merger arbitrage investments, we found no significant difference between the speculation spread in domestic and foreign Polish deals, between 2000 and 2013. However, we found higher returns for cross-border portfolio, therefore investors seem more pessimistic with regards to the expected risk in cross-border deals. Also, on average, deal spreads do not correctly reflect the level of risk in merger arbitrage strategies with Polish targets.

A Method for Winning at Lotteries

We report a new result on lotteries --- that a well-funded syndicate has a positive expectation risk arbitrage strategy in an equiprobable lottery with no take and no carryover pool. We prove that an optimal strategy for a syndicate in an equiprobable lottery with many uncoordinated bettors consists of betting one of each ticket (the ``trump ticket''). We show a similar result obtains for proportional ticket selection in non-equiprobable lotteries. The strategy can be adjusted to accommodate lottery taxes and carryover pools. No ``irrationality'' need be involved for the strategy to succeed (beyond the decision of the crowd to bet anything at all) --- it requires only that a large group of non-syndicate players each bet a few tickets without coordinating their choices.

Harmonious Stock Prices

Stock price movements in China still remain highly harmonious, in spite of the many significant regulatory and structural changes over the recent years. A survey of the literature reveals that harmony in the stock price movements is related to a few salient features in China’s capital market: high ownership concentration, high incidence of the use of pyramidal ownership structure, significant state ownership, and a lack of active institutional investors. In addition, we also point out that harmonious stock prices may generally result from low intensity of private information acquisitions by risk arbitrageurs.

Idiosyncratic Risk, Costly Arbitrage and Asymmetry: Evidence from Pairs Trading

This paper explains the idiosyncratic risk puzzle in a novel test setting with a combination of arbitrage risk and arbitrage asymmetry as in Stambaugh/Yu/Yuan (2015). We utilize the popular investment strategy pairs trading to identify a different kind of mispricing and find a dominant negative (positive) relationship among overpriced (underpriced) stocks between idiosyncratic volatility and returns in the US stock market between 1990 and 2014. The return rises for higher idiosyncratic risk levels, however not monotonically contrary to related papers. We clarify this issue with a profound analysis of the pairs trading’s algorithm and demonstrate how the technical drivers, volatility and correlation, influence returns. Our findings reveal why pairs trading’s profitability varies across markets, industries, over time, and firm characteristics, and how to improve the trading strategy. Double-sorted portfolios on volatility and correlation earn significant risk-adjusted monthly returns of up to 76bp, which is 43bp more than the traditional portfolio earns.(Extended Version of the paper Demystifying Pairs Trading: The Role of Volatility and Correlation (http://ssrn.com/abstract=2774063))

Systematic limited arbitrage and the cross-section of stock returns: Evidence from exchange traded funds

Abstract We propose a parsimonious, comprehensive proxy for innovations in limited arbitrage: innovations in ETFs’ premium. Consistent with a common component, we confirm limited arbitrage factors, LAFs, constructed from ETFs’ premium innovations spanning four asset classes are correlated. Further, we find that equity LAFs are negatively priced in the cross-section of stock returns. Our pricing tests also confirm that LAFs provide pricing information beyond well-known limits of arbitrage: illiquidity and idiosyncratic volatility. Overall, our findings suggest that limited arbitrage risk is priced and LAF is a relevant risk-factor.

The role of arbitrage risk on the elasticity of demand: New evidence from 100% secondary equity offerings

We examine the elasticity of demand curves using a recent sample of 100% secondary equity offerings (i.e., a large block of shares held by current shareholders; the proceeds of the sale go to the selling shareholders, not the issuing company) and employ measures of arbitrage risk that allow us to control for variation in arbitrage risk. We find that demand curves are inelastic for firms with high levels of arbitrage risk and elastic for all others. We also document that during the second half of our sample period demand curves are elastic for all stocks regardless of the arbitrage risk.

Ownership Structure, Limits to Arbitrage, and Stock Returns: Evidence from Equity Lending Markets

We examine how institutional ownership structure gives rise to limits to arbitrage through its impact on short-sale constraints. Stocks with lower, more concentrated, short-term, and less passive ownership exhibit lower lending supply, higher costs of shorting, and higher arbitrage risk. These constraints limit the ability of arbitrageurs to take short positions and delay the correction of mispricing. Stocks with more concentrated ownership exhibit smaller announcement day reactions, larger post-earnings announcement drift, and an additional negative abnormal return of 0.47% in the week following a positive shorting demand shock.Received June 16, 2014; accepted June 8, 2016 by Editor Laura Starks.

Ownership Structure and Limits to Arbitrage in the Equity Lending Market

We examine how institutional ownership structure gives rise to limits to arbitrage through its impact on short-sale constraints. Stocks with lower, more concentrated, short-term, and less passive ownership exhibit lower lending supply, higher costs of shorting, and higher arbitrage risk. These constraints limit the ability of arbitrageurs to take short positions and delay the correction of mispricing. Stocks with more concentrated ownership exhibit smaller announcement day reactions, larger post-earnings announcement drift, and an additional negative abnormal return of -0.47% in the week following a positive shorting demand shock.

Measuring States of Limited Arbitrage Using ETF Tracking Errors: Implications for Asset Pricing

We propose a parsimonious, comprehensive proxy for innovations in limited arbitrage: the divergence between the return on an ETF and the return on the underlying net asset value. Consistent with a common component, we confirm limited arbitrage risk-factors, LAF, constructed from return divergence spanning four asset classes are correlated. Consistent with well-known factors that limit arbitrage, increased volatility and market illiquidity, we find that equity LAFs are negatively priced in the cross-section of stock returns. However, our pricing tests confirm that LAFs also provide pricing information beyond well-known limits to arbitrage. Overall, our findings suggest that limited arbitrage risk is priced and LAF is a relevant risk-factor.

The Market's Assessment of the Probability of Meeting or Beating the Consensus

AbstractWe investigate to what extent the market uses information that is predictive of whether earnings will meet or beat the analyst consensus forecast of earnings (MBE henceforth): measures of a firm's incentives to engage in MBE behavior, measures of constraints on MBE, measures of past MBE practices by firm and industry, and other variables. Using the Mishkin test framework and Bonferroni‐adjusted p‐values, we document that of a total of 21 variables, the market inefficiently uses information in one difficulty measure and four other predictors, suggesting that strong empirically and theoretically grounded relationships concerning MBE behavior are more likely to be unraveled by the market. We further show that a portfolio based on the difference between the objective MBE probability and the market‐assessed MBE probability generates significant abnormal returns. The documented return anomaly is distinct from other known anomalies and cannot be fully explained by arbitrage risk or transaction costs.