Nonlinear limits to arbitrage

Jingzhi Chen; Charlie Cai; robert faff; Yongcheol Shin

doi:10.1002/fut.22320

Nonlinear limits to arbitrage

Jingzhi Chen, Charlie Cai, robert faff, Yongcheol Shin

Economics

Research output: Contribution to journal › Article › peer-review

Abstract

We study the nonlinear limits to arbitrage in a model. When mispricing is small,
arbitrage activity increases with mispricing because of the higher cost‐adjusted
return. However, at high levels of mispricing, arbitrageurs are deterred by larger
mispricing as funding constraints become more binding. Testing the model predictions on the index spot‐futures arbitrage with a Markov‐switching model, we
document an inverse U‐shaped relationship between mispricing and arbitrage
activity. The extreme regime is with the largest mispricing but least arbitrage
activity, and coincides with the market turmoil, suggesting that funding constraints
become the main driver behind the limit to arbitrage.

Original language	English
Pages (from-to)	1084-1113
Journal	The Journal of Futures Markets
Volume	42
Issue number	6
Early online date	28 Feb 2022
DOIs	https://doi.org/10.1002/fut.22320
Publication status	Published - Jun 2022

Bibliographical note

Keywords

index arbitrage, limits to arbitrage, Markov‐switching GECM, mispricing correction, noise momentum

Access to Document

10.1002/fut.22320Licence: CC BY

Nonlinear limits to arbitrage
© 2022 The Authors
Final published version, 4.13 MBLicence: CC BY

Cite this

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title = "Nonlinear limits to arbitrage",

abstract = "We study the nonlinear limits to arbitrage in a model. When mispricing is small,arbitrage activity increases with mispricing because of the higher cost‐adjustedreturn. However, at high levels of mispricing, arbitrageurs are deterred by largermispricing as funding constraints become more binding. Testing the model predictions on the index spot‐futures arbitrage with a Markov‐switching model, wedocument an inverse U‐shaped relationship between mispricing and arbitrageactivity. The extreme regime is with the largest mispricing but least arbitrageactivity, and coincides with the market turmoil, suggesting that funding constraintsbecome the main driver behind the limit to arbitrage.",

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AU - faff, robert

AU - Shin, Yongcheol

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