Objective The sole objective to develop a relationship amongst basis, arbitrage and volatility. Hypothesis: We assume that arbitrage, basis and volatility are interrelated to each other Contango = futures price > spot price. Backwardation = futures price < spot price. The level and the sign of basis (i.e. backwardation or contango) is referred to as a signal of the shortage or surplus of the physical commodity in the market. as the futures contract approaches its maturity date, the basis gets smaller, since the costs of storage are “no longer a factor” . At the time of maturity, basis diminishes to zero because spot and futures prices converge. If these price relationships do not hold, there are possible arbitrage opportunities in the market. Spot future parity For spot and futures prices to be related, spot- future parity should exist, which is the essence of the law of one price in futures markets. Spot- futures parity implies that stable arbitrage opportunities based on the spot-futures relationship are not possible. an equality condition that should in theory hold, or opportunities for arbitrage exist. Spot- future parity is an appliance of the law of one price. We expect that the spot price of an asset converges to that of the futures price as the delivery date of the contract approaches , otherwise an arbitrage opportunity exists. ARBITRAGE Attempting to profit by exploiting price differences of identical or similar financial instruments on different markets or in different forms. The ideal version is riskless arbitrage
Correlation between A positive corelationship as high as 99% Arbitrage strategy The exact nature of this relationship will depend : on the nature of the commodity (i.e. storable and non-storable) its relative importance in the world economy seasonal factors market expectations If the futures price stays above the spot price, we can buy the asset now and short a futures contract(i.e. agree to sell the asset later at the future price). If the futures price stays below the spot price, anyone who wants the asset should go long on a futures contract and accept delivery instead of paying the spot price. This convergence means the spot price may go up(down), the futures price may go down (up), or both Granger Causality Model To test this Causality we will use the Granger Causality Model to prove the direction of influence. The Granger Causality test assumes that the information relevant to the prediction of the respective variables is contained solely in the time series data of these variables. Result: Basis effects volatility
(whether positively/negatively) . Corelationship between basis and volatility.
A positive corelationshipas high as 99.68%
Conclusion Basis volatility and arbitrage move in sync