RELATIONSHIP BETWEEN YIELD FROM BASIS ARBITRAGE & IMPLIED VOLATILITY

Abstract

An Arbitrage is a simultaneous purchase & sale of a security, in different markets or in different market segments (For Eg. Spot market & Derivatives market), to benefit from the asset mispricing & a earn a risk-free profit. Arbitrage is considered to be risk-free, since no market fluctuations are speculated by the investor. opportunities Instead, they participate in arbitrage to manipulate security mispricing that has emerged between two connected markets. Therefore, owing to market inefficiencies, arbitrage mechanisms exist. Classical market theories say that the market, having both rational buyers and arbitrageurs, would take care of mispricing and would get stock prices down to their true basic price. But such mispricings still occur in the real world from time to time.Basis Arbitrage is an Arbitrage strategy where in an Arbitrageur benefits from the mispricing of securities. There is always a difference between the price of a security in Cash Segment & it’s derivative in Futures Segment. This differencebetween the prices is due to the Cost of Carry/Cost of Capital. Cost of carry or cost of capital corresponds to the expenses caused as a result of an investment position being taken. Such costs can include financial costs, such as the interest on bank loans used to acquire a security. They may also involve economic costs, such as the opportunity costs involved in taking up the initial position, or any other costs such as those linked to commodity storage.Attractive Arbitrage opportunities may exist for a few seconds, & also require continuous monitoring of various securities across segments, across markets. Therefore, for practically benefitting from the Arbitrage strategies, a trader should employ technology & try to automate the procedure as much as possible. It has been widely believed by the market participants that an Increase in Volatility leads to higher yields by employing Arbitrage strategies. During the process of Research, the author was unable to locate any substantial document confirming thisperception. The investment community deals with huge sums of money & should not have any misconceptionor follow any unproven theory as this may lead to severe repercussions.Through this study, we intend to solvethis problem by verifying that whether this belief is true or not.