Academic journal article The Journal of Business and Economic Studies

Arbitrage in International Markets

Academic journal article The Journal of Business and Economic Studies

Arbitrage in International Markets

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Consider a model with two equity markets, home and foreign, each arbitrage free and endowed with an investor. There are no barriers to financial trade between markets, no taxes or transaction costs. In such setting the possibility of arbitrage between those markets, from the perspective of the home investor, exists. The empirical results suggest that a simple measure, the difference in Sharpe ratios between the home and foreign markets as perceived by a home based investor, taken to be a U.S. investor, indicates the existence of arbitrage opportunities and seems to influence portfolio investment.

Arbitrage is defined as "the simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices" (Sharpe and Alexander, 1990). Arbitrageurs, by trading to profit from price differentials between similar assets in different markets, eliminate such mispricing and bring prices in line with fundamental values (Shleifer and Vishni, 1997).

The idea of arbitrageurs profiting from every opportunity and eliminating all price differences is not realistic, partially due to the risky nature of arbitrage operations (Shleifer and Vishni, 1997), to the point that sometimes arbitrageurs leave opportunities untouched (Kondor, 2009). Along these lines, Pontiff (2006) recognizes the possibility of mispricing even in the presence of arbitrageurs, mostly due to costs arising from idiosyncratic risks. Gagnon and Karolyi (2010), in a study encompassing 506 cross listed stocks, recognize economically small but very volatile deviations from price parity. In agreement with Pontiff (2006), they find the highest cost for arbitrageurs to be related to idiosyncratic risk. When arbitrage opportunities are left untouched, the equalization of prices for similar assets across markets will likely not occur, implying that the prices of these assets do not necessarily reflect fundamental values.

Several of the studies on arbitrage in international markets focus on the differences in price, when expressed in a common currency, of cross listed stocks. Examples of such studies include: Gagnon and Karolyi (2010); Chan, Hong, and Subrahmaniam (2008); Bluin, Hail, and Yetman (2009); and De Jong, Rosenthal, and Van Dijk (2009). These studies agree on the existence of arbitrage across markets for the stocks in their samples, giving as reasons for the persistence of small mispricings the existence of costs ranging from tax differentials (Bluin et al. 2009) to idiosyncratic risk (De Jong, Rosenthal, and Van Dijk 2009). Licht (2001) discuss the effects on arbitrage of the laws in different countries; he posits the equalization of prices provided by arbitrageurs to reflect, among other factors, the differential effects of the laws in the countries where the stock is listed.

Following a different approach, Delbaen and Shirakawa (1996) use an equivalent probability measure to generate a theoretical no arbitrage condition in the currency markets. It is worth noting that their result is not dependent on a subset of currencies, rather it is a general no arbitrage condition that applies to all currencies. Following their path this study focuses on markets, proxied by their indexes, and presents a general, though simple, measure of arbitrage independent of any particular stock.

Since approximately the 1990s, several financial markets in developing countries opened to trade with the rest of the world (Bekaert and Campbell 2000, Licht 2001). Possibly related with the opening of these new markets, the global portfolio investment increased. Data from the Coordinated Portfolio Investment Survey (CPIS), conducted by the International Monetary Fund (IMF), shows the value of total world portfolio investment in equities to have increased from 1.6 trillion U.S. dollars in the year 2001 to 5.3 trillion U.S. dollars in the year 2012, a compounded growth of around 8. …

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