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The implied arbitrage mechanism in financial markets

Shiyi Chen, Michael T. Chng and Qingfu Liu

Journal of Econometrics, 2021, vol. 222, issue 1, 468-483

Abstract: The no-arbitrage condition is a cornerstone concept in financial market research. However, the arbitrage mechanism that is inherent in the trading process for related securities, is not readily observable. We develop a generalized smooth-transition vector error-correction model, or GST-VECM, to estimate the arbitrage mechanism from financial market data. The GST-VECM can (i) back out the implied no-arbitrage band, (ii) estimate arbitrage intensity for upper and lower bound violations, and (iii) accommodate convergence risk for statistical arbitrage. Using the introduction of CSI300 ETF trading in China as a natural experiment, we estimate the GST-VECM to reveal some insight into how a microstructural policy, by altering the index arbitrage mechanism, affects the pricing link between spot and futures markets.

Keywords: No-arbitrage band; Limits to arbitrage; Carry-cost adjusted basis (search for similar items in EconPapers)
JEL-codes: G14 G15 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1016/j.jeconom.2020.07.011

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Journal of Econometrics is currently edited by T. Amemiya, A. R. Gallant, J. F. Geweke, C. Hsiao and P. M. Robinson

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