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Direct Tests of Index Arbitrage ModelsRobert Neal |
ABSTRACT Previous tests of stock index arbitrage models have rejected the no-arbitrage constraint imposed by these models. This paper provides a detailed analysis of actual S&P 500 arbitrage trades and directly relates these trades to the predictions of index arbitrage models. An analysis of arbitrage trades suggests that (i) short sale rules are unlikely to restrict arbitrage, (ii) the opportunity cost of arbitrage funds exceeds the Treasury Bill rate, and (iii) the average price discrepancy captured by arbitrage trades is small. Tests of the models provide some support for a version of the arbitrage model that incorporates an early liquidation option. The ability of these models to explain arbitrage trades, however, is relatively low. Robert Neal is an economist at the Federal Reserve Bank of Kansas City. The author thanks Hank Bessembinder, Cathy Bonser-Neal, Kalok Chan, Peter Chang, Dexter Earle, Dean Furbush, Avi Kamara, Jim Overdahl, Jeff Pontiff, David Rodgers, Eduardo Schwartz, Catherine Shalen, Jim Shapiro, Dan Siegel, George Sofianos, Ann Fremault Vila, and the seminar participants at Arizona State University, the Commodities Futures Trading Commission, Indiana University, the University of Washington, and Washington State University for their comments and discussions. Thanks also go to the New York Stock Exchange for providing the data. The views expressed herein are solely those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.Back to top RWP home |