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

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

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 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: f1,
f2, …, fm, and n kinds of domestic special risk factors: f1’,f2’, …, fn’, 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).

Pi j   i j    imj f m    inj ' f 'n  i (1)

m n

In equation (1) , Pij is the price of domestic asset i measuring by another country’s currency j.
And α ij is the constant term, βimj and β inj’ 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).

PAj,t   Aj ,t   A1,t f1,t   A 2,t f 2,t     Am,t f m,t   A,t (2)

PBj,t   Bj ,t   B' 1,t f1,t   B' 2,t f 2,t     Bn

'
,t f n ,t   B ,t (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).

PAj,t  PBj,t  ( Aj ,t   Bj ,t )  (  Am ,t f m,t    Bn

'
,t f n ,t ) (4)
m n

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

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 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).

PAj,t 1  PBj,t 1  ( Aj ,t   Bj ,t )  (  Am,t f m ,t 1    Bn

'
,t f n ,t 1 ) (5)
m n

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, αjA,t-αjB,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.

PAj,t 1  PBj,t 1  ( Aj ,t   Bj ,t )  (  Am,t f m,t 1    Bn

'
,t f n ,t 1 )
m n

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.

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 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.

PAj,t 1  PBj,t 1  ( Aj ,t   Bj ,t )  (  Am ,t f m ,t 1    Bn
'
,t f n ,t 1 )
m n

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

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 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.

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 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

Trace tests Maximum eigenvalue tests
Hypothesis Eigenvalue
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).

GFA  0.9959* GSA 0.0327 * OIL  0.0215* SP500 (6)

(0.00317) (0.3511) (0.00435)

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).

SDG  0.0591* GSA 0.0786* OIL  0.014* HS 300 (7)

(0.01267) (0.07246) (0.00225)

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

GFA  SDG  0.9368* GSA  0.1113* OIL  0.0215* SP500  0.014 * HS 300 (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.

GFA  SDG  97  0.9368* GSA  0.1113* OIL  0.0215* SP500  0.014 * HS 300 (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

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 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
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 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,
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[10] Johansen, S., Katarina, J., “Maximum likelihood estimation and inferences on cointegration-with
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[11] Johansen, S., “Estimation and hypothesis testing of cointegration vectors in Gaussian vector
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