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**Weizhong Chen, Xin Zhan, Xu Xu
**

Journal of Convergence Information Technology, Volume 6, Number 1. January 2011

A Novel Approach to Analyze the Trigger Condition of International

Arbitrage

Weizhong Chen, Xin Zhan

*corresponding author

, Xu Xu

School of Economics and Management

Tongji University

Shanghai, China

E-mail:chen_wz@mail.tongji.edu.cn;zhanxin_1984@163.com;08xuxu@tongji.edu.cn

doi:10.4156/jcit.vol6. issue1.5

Abstract

Based on international multiple risk factors model, a novel approach is introduced to determine the

opportunity of international arbitrage. The integrated approach includes replica technology for assets’

spread, relativity test, and time series analysis of the assets’ prices in the portfolios. Then an empirical

study is done by using the assets’ prices related to gold in America and Chinese Markets.

Keywords: Arbitrage, Relativity, Time Series Analysis, Factors’ Deviation

1. Introduction

Preventing the inflow of hot money and the followed harmful arbitrage behavior is an important aim

for a government to maintain the stability and safety of its financial economy. To achieving this object,

the government should regulate and control the prices of domestic assets, which have high relativity

with the same or similar assets abroad. The strategies include keeping the proper spread of the assets to

knock them into the neutral interval of non-arbitrage; using trade barrier and capital controls which can

increase the arbitrage cost to eliminate the potential or existing speculate exposures. Basically, the

realization of the policies are all relied on the trigger condition of arbitrage opportunity, because the

aim of regulate and control is to make the trigger condition invalid. So choosing an exact approach to

decide the trigger condition of arbitrage is the precondition for the government to make effective

strategies.

Recent studies on the decision to trigger condition of international arbitrage can be concluded in two

aspects. The first approach is based on ‘the Law of One Price’. Under the assumption that without any

transaction cost, the approach uses the spread of the same assets’ prices in different markets directly to

determine whether the arbitrage opportunity exists. For examples, in exchange rate arbitrage, the

arbitrager or government can compare the direct price and indirect price of one currency to decide the

existence of arbitrage opportunity. Ma [1], Xu et al. [2] used this method to analyze the arbitrage

chance in global exchange markets. In the arbitrage of commodities and stock indices, the history

spread of the assets is used to be the benchmark for the decision of arbitrage opportunity. If the spread

of the assets which have high relativity exceeds the normal one (above the upper bond or below the

lower bond), the arbitrager can establish the positions at this moment, and cover all the positions when

the spread becomes narrow or widen. Girma and Paulson [3] used this method to search for the

arbitrage opportunities in different crude oil futures contract. Tang and Chen [4] also estimated the

position ratios of arbitrage assets based on this method.

The second approach usually used in the research which considers arbitrage costs, is named ‘Costs

and Earnings Method’. That means if the earnings is higher than the costs, the arbitrage opportunity

exists. In the study of interest rate and exchange rate arbitrage, Branson [5], Frenkel and Levich [6],

Blenman [7] all deeply researched on the influence of costs to the neutral interval of covered interest

rate arbitrage. In the study of commodity futures arbitrage, Zhou et al. [8] introduced non-arbitrage

conditions for inter market spreads between LME and SHFE copper futures by considering the

arbitrage costs which included trading margin and fixed costs, and then came to a conclusion that the

arbitrage opportunity was no more than 5 percent in each year by comparing the costs and earnings.

But both of the above approaches have some shortages in practical application. For the first

approach, there will be a high risk to judge the arbitrage opportunity directly relying on the history

- 41 -

A Novel Approach to Analyze the Trigger Condition of International Arbitrage

Weizhong Chen, Xin Zhan, Xu Xu

Journal of Convergence Information Technology, Volume 6, Number 1. January 2011

spread. For one thing, the extreme prices will make this approach unavailable; for another, under the

condition of efficient and opening market, the interval of history spread will become too narrow to

make this approach able to use under the constraint of arbitrage costs. For the second approach, most

studies in recent years all focused on the arbitrage among the same kind of assets, hardly any research

on different kinds of assets with high relativity. This phenomenon will make it difficult for the

government to discover many potential arbitrage opportunities, and further more make the control

range for the arbitrage objects to be narrow.

In conclusion, it is necessary to make further efforts to improve the approach to judge whether there

is an arbitrage opportunity. And the new approach should satisfy two conditions as follows: First, the

applied range of this approach should be widen for the same and similar assets in global markets;

second, the new approach should be valid in a long section of time. So this article will establish a

multiple factors model refer to international arbitrage pricing theory. Based on the model, a new

concept “Factors’ deviation” is introduced to be the new rule for determining the arbitrage opportunity.

After deeply research on its mechanisms, an empirical study is done by using the assets’ prices related

to gold in American and Chinese markets.

2. Analysis on the arbitrage mechanisms based on multiple factors model

Based on the international arbitrage pricing theory (IAPT) which was suggested by Solnik [9],

assume that in a time quantum: t=1, 2, …, T, there are m kinds of international common risk factors: f

1

,

f

2

, …, f

m

, and n kinds of domestic special risk factors: f

1

’

,f

2

’

, …, f

n

’

, which influence the prices of the

assets in the market. With a constraint condition that the number of m plus n is much less than the

number of the assets, a multiple risk factors model can be described as equation (1).

' '

j j j j

i i im m in n i

m n

P f f o | | u = + + +

¯ ¯

(1)

In equation (1) , P

i

j

is the price of domestic asset i measuring by another country’s currency j.

And α

i

j

is the constant term, β

im

j

and β

in

j’

are the sensitive coefficients of the assets to the

international and domestic risk factors, µ

i

is the residual.

Assume only considering two assets A and B in the markets, according to the multiple factors

model, their prices’ representations at time t can be revealed as equation (2) and (3).

, , 1, 1, 2, 2, , , ,

j j

A t A t A t t A t t Am t m t A t

P f f f o | | | u = + + + + + (2)

' ' '

, , 1, 1, 2, 2, , , ,

j j

B t B t B t t B t t Bn t n t B t

P f f f o | | | u = + + + + + (3)

Because there will be some specific factors exist in different assets, some β in equation (2)

and (3) may equal to zero. Generally, the precondition to establish an arbitrage portfolio using

A and B is that the assets’ prices should have high relativity. Furthermore, high relativity of

prices also means that the risk factors and the sensitive coefficients are mainly same. So

equations (2) and (3) have a same portfolio of risk factors.

Omitting the residual in equations (2) and (3), the spread model of asset A and B can be

expressed as equation (4).

'

, , , , , , , ,

( ) ( )

j j j j

A t B t A t B t Am t m t Bn t n t

m n

P P f f o o | | ÷ = ÷ + ÷

¯ ¯

(4)

The practical significance of equation (4) is that use the spread of portfolios include risk

factors and a constant term to replicate the real spread of assets’ prices. Assume asset A and B

have high relativity, then the deviation of their prices or the change of the spread can be due to

the change of the spread of portfolios including risk factors. Because the non-arbitrage

condition of A and B is that they should maintain a stable spread of prices at any time, so if

- 42 -

A Novel Approach to Analyze the Trigger Condition of International Arbitrage

Weizhong Chen, Xin Zhan, Xu Xu

Journal of Convergence Information Technology, Volume 6, Number 1. January 2011

some risk factors’ deviation in equation (4) causes the change of prices’ spread, the non-

arbitrage condition will be broken, and there will be an arbitrage opportunity.

3. A new trigger rule of arbitrage based on factors’ deviation

This part will introduce a new concept “Factors’ deviation” to deeply explain the trigger rule of

international arbitrage. According to the multiple risk factors model and prices’ spread model, Factors’

deviation means in a short period [t, t+1], one or several risk factors deviate from the normal values;

this makes the assets’ prices change, furthermore the spread will be wide or narrow, then the arbitrage

opportunity appears. Assume the spread of asset A and B at time t+1 is P

j

A,t+1

-P

j

B,t+1

, the risk factors

and the sensitive coefficient is stable in a short period, then the spread of asset A and B at time t+1

can be expressed as equation (5).

'

, 1 , 1 , , , , 1 , , 1

( ) ( )

j j j j

A t B t A t B t Am t m t Bn t n t

m n

P P f f o o | |

+ + + +

÷ = ÷ + ÷

¯ ¯

(5)

According to equation (5), the mechanisms of arbitrage trigger rule based on Factors’

deviation can be described in figure 1.

Figure 1. The mechanisms of arbitrage trigger rule based on Factors’ deviation

If using the vertical axis to represent the left part of equation (5), and using the lateral axis to

represent the second part of equation (5)’s right, the change of the portfolios’ spread or the predicted

value according to the multiple factors model; then the parity curve of multiple factors is the line pass

through the point (0, α

j

A,t

-α

j

B,t

) and has an angel of 45 degree with the lateral axis. Using the spread at

time t as the benchmark, the spread of asset A and B is in equilibrium state at time t+1 on the parity

curve of multiple factors. Considering the arbitrage costs, there will be a neutral interval around the

parity curve. In the neutral interval, such as point X, the arbitrage trigger condition is not valid. But if

at some time, the point X biases outside of the arbitrage boundary caused by Factors’ deviation, such as

point Y and Z, the arbitrage opportunity exists.

At point Y, the relationship of the spread of real assets’ prices and the influence of the risk factors’

deviation can be expressed by the inequality as follow.

'

, 1 , 1 , , , , 1 , , 1

( ) ( )

j j j j

A t B t A t B t Am t m t Bn t n t

m n

P P f f o o | |

+ + + +

÷ > ÷ + ÷

¯ ¯

The spread of real assets’ prices is higher than the influence of the risk factors’ deviation, or in

another way, higher than the predicted value by using multiple factors model at time t+1. According to

this, the arbitrager can establish the arbitrage positions by selling the expensive asset and buying the

cheap one, and can gain the profit by covering the position when the spread lessen.

- 43 -

A Novel Approach to Analyze the Trigger Condition of International Arbitrage

Weizhong Chen, Xin Zhan, Xu Xu

Journal of Convergence Information Technology, Volume 6, Number 1. January 2011

By the same rule, at point Z, another inequality can be revealed as follow.

'

, 1 , 1 , , , , 1 , , 1

( ) ( )

j j j j

A t B t A t B t Am t m t Bn t n t

m n

P P f f o o | |

+ + + +

÷ < ÷ + ÷

¯ ¯

The real spread is lower than the predicted spread at time t+1. So the arbitrager can sell the cheap

asset and buy the expensive one to establish the arbitrage positions, and can gain the profit by covering

the positions when the spread widen.

In summary, the mechanisms of the new approach to analyze the trigger condition of arbitrage can

be revealed as follows: The traditional basic rule, “the Law of One Price”, can be expanded from

“parity of price” to “parity of the portfolio of risk factors”. In a short period, if most of the risk factors

are stable, then the increase or decrease of the factors and the deviation of the special factors will make

the spread of the assets wide or narrow, thus the arbitrage opportunity will exists. Compared with

“Costs and Earnings Method”, the new approach can predict the value of the assets much better, and

then the operation of arbitrage will be much easier. Based on the new approach, if only got the main

risk factors and the sensitive coefficients of the assets, the spread of the assets in the future can be

predicted. Using the predicted values as the benchmark, we will be able to judge whether the real

spread is wide or narrow, and furthermore judge whether the assets’ prices satisfy the trigger condition

of arbitrage.

It is special need to point out that if there are some common risk factors among asset A and B, then

through proper hedging, the spread of the assets can transfer to the spread of a small quantity of

remaining factors, and the prediction will be much exact.

4. An empirical study on the trigger condition of arbitrage by time series analysis

4.1. Instruction of the date and the arbitrage objects be chosen

The article uses the assets related to gold in American and Chinese markets to be the arbitrage

objects. The time interval is from January 9, 2008 to July 16, 2010. Choose the followed assets as

probable arbitrage objects: American gold spot price (GSA) and the futures price (GFA), the stock

price of American Gold Company (UXG); Chinese gold spot price (GSC) and the futures price (GFC),

the stock price of Shandong gold company (SDG). Choose the followed assets as the explanatory

variables: the price of crude oil futures (OIL), Shanghai and Shenzhen index (HS300), S&P500 index

(SP500), American dollar index (USD) and CRB index from American Commodity Research Bureau

(CRB). Choose the exchange rate between U.S. dollar and Chinese Yuan for converting the assets’

prices in different country. All the assets’ weekly settlement price can be found from WIND data base.

There are still some added instructions for the date: If using the daily date, there will be a lot of

discontinuity points because of different holidays in America and China. If using the monthly date, the

sample points will be too little to do empirical study effectively. Using weekly date can avoid the

shortages. Except the International Labor Day, the Spring Festival and National day of China, all the

data are continuous. The total number of samples is 129, and it is enough for the study.

First, using the assets’ prices of America times the exchange rate, then doing the correlation analysis

of all the objective assets. Table 1 shows the result.

Table 1. Correlation coefficients of American and Chinese assets

GFA GFC GSA GSC SDG UXG

GFA 1 0.97 1.00 0.99 0.90 0.76

GFC 0.97 1 0.97 0.98 0.90 0.76

GSA 1.00 0.97 1 0.99 0.90 0.76

GSC 0.99 0.98 0.99 1 0.90 0.76

SDG 0.90 0.90 0.90 0.90 1 0.77

UXG 0.76 0.76 0.76 0.76 0.77 1

- 44 -

A Novel Approach to Analyze the Trigger Condition of International Arbitrage

Weizhong Chen, Xin Zhan, Xu Xu

Journal of Convergence Information Technology, Volume 6, Number 1. January 2011

Table 1 shows the correlation coefficients of American and Chinese gold price are all above 0.97.

This result can explain why these assets are often used for international arbitrage. For the stock prices,

the correlation coefficients of American gold company (UXG) with the other assets is lower than 0.8,

so it can’t be the arbitrage object. But the correlation coefficients of Shandong gold company (SDG)

with the American gold and futures are both equal to 0.9, so they can be used for risk arbitrage.

According to this, the article will choose Shandong gold company (SDG) and American gold futures

(GFA) as the arbitrage objects for further study.

4.2. Establish the multiple factors model by processing the time series

It can be seen from the above text, if we want to get the trigger condition of international arbitrage

in the next period, the primary thing we should do is ascertaining the risk factors. After using other

researchers’ approaches and trying many empirical testing, we find that the correlation coefficient of

American gold futures with dollar index is less than 0.1, with CRB index is about 0.2, so we remove

the two explanatory variables. Finally we choose global crude oil price (OIL) and American gold price

(GSA) as the common risk factors, and Shanghai and Shenzhen index (HS300) and S&P500 index

(SP500) as the specific risk factors.

The American market is studied at first. The multiple factors model is established by using

EVIEWS 5.0. Using augment Dickey-Fuller test to do unit root test of each variables, the result is

revealed in table 2.

Table 2. Results of unit root tests

Variable ADF value Prob. Stationary

GFA -0.90 0.7843 No

GSA -0.93 0.7750 No

OIL -1.28 0.6400 No

SP500 -1.85 0.3572 No

D(GFA) -11.12 0.0000 Yes

D(GSA) -11.45 0.0000 Yes

D(OIL) -11.16 0.0000 Yes

D(SP500) -11.86 0.0000 Yes

Note. The critical values are -3.48 and -2.88 for rejecting the null hypothesis at the 0.01 and 0.05 levels

Table 2 shows that all the variables become stationary through first difference. So we can do

cointegration analyze on these series to discover the long term equilibrium between American gold

futures and the other variables. We establish the Vector auto regression (VAR) model and use Akaike

information criterion (AIC), Schwarz criterion (SC) and other criterions to choose the proper lag order.

Table 3 shows the best lag order is 1.

Table 3. Results of VAR lag order selection

Lag LR FPE AIC SC HQ

0 NA 7.69E+11 38.72047 38.8087 38.75632

1 1004.408 3.19e+08* 30.93136* 31.37252* 31.11062*

2 23.88057 3.35E+08 30.98016 31.77424 31.30282

3 30.48195* 3.31E+08 30.96578 32.11279 31.43185

4 13.03195 3.78E+08 31.09661 32.59655 31.70608

Note. * indicates lag order selected by the criterion

Then the Johansen test [10-11] indicates that there is a cointegration relationship between American

gold futures’ price and the other three variables. Table 4 shows the results of cointegration tests.

- 45 -

A Novel Approach to Analyze the Trigger Condition of International Arbitrage

Weizhong Chen, Xin Zhan, Xu Xu

Journal of Convergence Information Technology, Volume 6, Number 1. January 2011

Table 4. Results of cointegration tests

Hypothesis Eigenvalue

Trace tests Maximum eigenvalue tests

Statistic P value Statistic P value

None * 0.312103 68.2517 0.0002 49.3833 0.0000

At most 1 0.091026 18.8684 0.5024 12.5980 0.4899

At most 2 0.035403 6.2704 0.6636 4.7579 0.7720

At most 3 0.011393 1.5125 0.2188 1.5125 0.2188

Note. * denotes rejection of the hypothesis at the 0.05 level

Further we get the long term equilibrium equation of the variables as equation (6).

(0.00317) (0.3511) (0.00435)

0.9959* 0.0327* 0.0215* 500 GFA GSA OIL SP = + ÷

(6)

The numbers in the brackets mean the standard deviations of the variables. Using the same method and

process, we can also get the long term equilibrium equation of stock price of Shandon gold company

(SDG), crude oil price (OIL), American gold price (GSA) and the index price of Shanghai and

Shenzhen (HS300) as equation (7).

(0.01267) (0.07246) (0.00225)

0.0591* 0.0786* 0.014* 300 SDG GSA OIL HS = ÷ +

(7)

Using equation (6) to minus equation (7), the spread is revealed as equation (8).

0.9368* 0.1113* 0.0215* 500 0.014* 300 GFA SDG GSA OIL SP HS ÷ = + ÷ ÷ (8)

The correlation analysis indicates that the correlation coefficient of equation (8)’s left and right part is

0.99. So the right part of equation (8), the spread of risk factors, can well reflect variation trend of the

left part which represents the spread of real assets’ prices. Based on least square method, we add a

constant term to the right part to rectify the equation, and this will make the value of the two parts

closer. Equation (9) shows the result.

97 0.9368* 0.1113* 0.0215* 500 0.014* 300 GFA SDG GSA OIL SP HS ÷ = + + ÷ ÷ (9)

4.3. Determine the trigger condition and test its validity in short term

Substitute the time series dates into equation (9), we can draw the trend graph of real assets’ prices’

spread and rectified portfolios’ spread of risk factors as figure 2.

Figure 2. The trend graph of real assets’ prices’ spread and rectified portfolios’ spread of risk factors

- 46 -

A Novel Approach to Analyze the Trigger Condition of International Arbitrage

Weizhong Chen, Xin Zhan, Xu Xu

Journal of Convergence Information Technology, Volume 6, Number 1. January 2011

Figure 2 shows that the two trend lines were coincident since the second half year of 2008.

This means the point set, (spread of real assets’ prices, portfolios’ spread of risk factors), all dropped

into the neutral interval of non-arbitrage at this period. Only in the first half year of 2008 there existed

difference between the two lines. Ignoring the transaction costs, the arbitrage opportunity probably

existed.

Obviously, the spread model, equation (9) should be available in the next short period at least.

Using the daily date of all the variables in equation (9) from July 19, 2010 to August 6, 2010, a validity

test for equation (9) is done, furthermore to analyze the arbitrage opportunity in the short term by this

model. Figure 3 shows the result of the model’s validity test.

Figure 3. The result of the model’s validity test

The two spread lines are almost the same, and the correlation coefficient of the test values is 0.98.

So the model can well fit the change of the assets’ spread, and it also indicates that there is no arbitrage

opportunity in this period.

5. Conclusion

The article tries to analyze the trigger condition of arbitrage based on factors’ deviation. The

main mechanisms are using portfolios of risk factors to replicate the original assets, and then

the assets’ spread can transfer to risk factors’ spread. The non-arbitrage rule can be expanded from

“parity of price” to “parity of the portfolio of risk factors”. The practical importance is expanding the

range of arbitrage objects. For regulating and controlling, the government should not only maintain the

normal spread of assets with strong relativity in domestic and foreign markets, but also keep away the

arbitragers using the substitution or complementation of the assets to establish arbitrage portfolio.

6. References

[1] Ma, M., “Generalized foreign exchange arbitrage: an indicator and a possible optimal arbitrage

path”, China Economic Quarterly, vol. 3, supp, pp.65-76, 2004.

[2] Xu, X. M., Chen, H. M., Yuan, Q., “Optimizing the method of seeking for the foreign exchange

arbitrage route”, The Journal of Quantitative & Technical Economics, no. 2, pp.76-85, 2006.

[3] Girma, P. B., Paulson, A. S., “Risk arbitrage opportunities in petroleum futures spreads”, The

Journal of Futures Markets, vol. 19, no. 8, pp.931-955, 1999.

[4] Tang, Y. W., Chen, G., “Estimating of the position ratio of static optimal futures spread”, Systems

Engineering, vol. 26, no. 1, pp. 51-56, 2008.

[5] Branson, W. H., “The Minimum covered interest differential needed for international arbitrage

activity”, Journal of Political Economy, vol. 77, no. 6, pp.1028-1035, 1969.

[6] Frenkel, J. A., Levich, R. M., “Transaction costs and interest arbitrage: Tranquil versus Turbulent

Period”, Journal of Political Economy, vol. 85, no. 6, pp.1209-1216, 1977.

- 47 -

A Novel Approach to Analyze the Trigger Condition of International Arbitrage

Weizhong Chen, Xin Zhan, Xu Xu

Journal of Convergence Information Technology, Volume 6, Number 1. January 2011

[7] Blenman, “A model of covered interest arbitrage under market segmentation”, Journal of Money,

Credit & Banking, vol. 23, no. 4, pp.706-717, 1991.

[8] Zou, Y., Liu, H. L., Wu, C. F., “An empirical analysis on the intermarket spreads between

Shanghai Futures Exchange and London Metal Exchange Copper Futures”, Systems Engineering-

Theory Methodology Application, vol. 13, no. 2, pp.142-146, 2004.

[9] Solnik, B. H., “International arbitrage pricing theory”, Journal of Finance, vol. 38, no. 2, pp.449-

457, 1983.

[10] Johansen, S., Katarina, J., “Maximum likelihood estimation and inferences on cointegration-with

applications to the demand for money”, Oxford Bulletin of Economics and Statistics, vol. 52, no.

2, pp.169-210, 1990.

[11] Johansen, S., “Estimation and hypothesis testing of cointegration vectors in Gaussian vector

autoregressive models”, Econometrica, vol. 59, no. 6, pp.1551-1580, 1991.

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