Arbitrage and Its Physical Limits

53 Pages Posted: 15 May 2017 Last revised: 17 May 2017

See all articles by Louis H. Ederington

Louis H. Ederington

University of Oklahoma - Division of Finance

Chitru S. Fernando

University of Oklahoma - Michael F. Price College of Business

Kateryna V. Holland

Purdue University - Division of Finance

Scott C. Linn

University of Oklahoma - Michael F. Price College of Business

Date Written: May 16, 2017

Abstract

We extend the Limits to Arbitrage literature by studying how physical constraints affect financial arbitrage in commodity markets. Using the U.S. crude oil market as our experimental setting, we document substantial economically significant violations of the no-arbitrage futures pricing conditions due to storage capacity constraints at the WTI futures delivery hub. We also find evidence of financial constraints. Our findings are robust to different measures of physical constraints, and controls for potential effects of U.S. Oil Fund rolls. Our results highlight the importance of both physical and financial arbitrage limits in pricing commodity futures. We also contribute to the Theory of Storage literature, which has largely ignored storage limits, by documenting the effects of finite storage capacity.

Keywords: Limits to Arbitrage, Commodity Markets, Theory of Storage, Oil Futures Market, Physical Constraints, Cash-And-Carry Arbitrage

JEL Classification: G13, G18, Q41

Suggested Citation

Ederington, Louis H. and Fernando, Chitru S. and Holland, Kateryna V. and Linn, Scott C., Arbitrage and Its Physical Limits (May 16, 2017). Available at SSRN: https://ssrn.com/abstract=2967892 or http://dx.doi.org/10.2139/ssrn.2967892

Louis H. Ederington

University of Oklahoma - Division of Finance ( email )

Norman, OK 73019
United States
405-325-5591 (Phone)
405-325-7688 (Fax)

Chitru S. Fernando (Contact Author)

University of Oklahoma - Michael F. Price College of Business ( email )

Adams Hall
307 West Brooks Street
Norman, OK 73019-4004
United States
405-325-2906 (Phone)
405-325-7688 (Fax)

HOME PAGE: http://faculty-staff.ou.edu/F/Chitru.Fernando-1/

Kateryna V. Holland

Purdue University - Division of Finance ( email )

MGMT KRAN, 403 West State Street
West Lafayette, IN 47907-2056
United States

Scott C. Linn

University of Oklahoma - Michael F. Price College of Business ( email )

307 West Brooks
Norman, OK 73019-4004
United States
405-325-3444 (Phone)
405-325-1957 (Fax)

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