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How Wide Is the Border?Charles Engel |
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. Charles Engel is a professor of economics at the University of Washington and a research associate with the National Association of Economic Research. John H. Rogers is an economist at the Board of Governors of the Federal Reserve System. The authors thank the participants in the workshops at the Federal Reserve Board, the Federal Reserve Banks of Kansas City and New York, the NBER Summer Institute, Columbia, Indiana, Michigan State, Penn State, Santa Cruz, UCLA and Washington for very helpful comments. We thank Kelley Lewis, Tim Schmidt and Mary Ellen Show for research assistance. Some of the work on this project was done while Engle was a Visiting Scholar at the Federal Reserve Bank of Kansas City. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Board of Governors or the Federal Reserve System. The National Science Foundation provided support for this project under grant number SBR-932078.Back to top RWP home |