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Nonlinear limits to arbitrage

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JournalThe Journal of Futures Markets
DateAccepted/In press - 3 Feb 2022
DateE-pub ahead of print (current) - 28 Feb 2022
Number of pages30
Early online date28/02/22
Original languageEnglish

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.

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© 2022 The Authors

    Research areas

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

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