Estimating unknown arbitrage costs: Evidence from a 3-regime threshold vector error correction model

Kristyna Ters and Jörg Urban

Journal of Financial Markets, 2020, vol. 47, issue C

Abstract: We present a methodology for estimating a multivariate 3-regime threshold vector error correction model (TVECM) with an unknown cointegrating vector based on a new dynamic grid evaluation. This model is particularly useful for estimating deviations from parity conditions, such as unknown arbitrage costs in markets with a persistent non-zero basis between two similar financial market instruments traded in the spot and derivative markets. Our proposed 3-regime TVECM can estimate the area where arbitrageurs have no incentives to trade. It is only when the basis exceeds a critical threshold, that is when the potential gain from the basis trade exceeds the overall transaction costs, that we expect arbitrageurs to step in and carry out the respective trade. This leads to non-linear adjustment dynamics and regimes with different characteristics. Our methodology allows overall transaction costs to be quantified in markets where trading costs are opaque or unknown.

Keywords: Arbitrage; Error correction; Regime switch; Threshold; Transaction cost (search for similar items in EconPapers)
JEL-codes: G12 G14 G15 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S1386418119300084
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:finmar:v:47:y:2020:i:c:s1386418119300084

DOI: 10.1016/j.finmar.2019.07.002

Access Statistics for this article

Journal of Financial Markets is currently edited by B. Lehmann, D. Seppi and A. Subrahmanyam

More articles in Journal of Financial Markets from Elsevier
Bibliographic data for series maintained by Catherine Liu ().