Do transaction costs prevent arbitrage in the market for crude oil? Evidence from a threshold autoregression

Abstract

Recent evidence suggests that transaction costs may prevent arbitrage in the market for crude oil. If these costs are significant, they could have serious implications for the value of the basis as a predictor of movement in the spot price.

Given the importance of the basis within the existing literature, this article investigates the effect of transaction costs on its dynamics. Using a threshold autoregression model, transaction costs are found to increase the persistence of the basis in most periods, suggesting the absence of arbitrage.

Keywords:

• crude oil
• basis
• threshold
• transaction cost

JEL Classification:

• Q40
• C22

Notes

¹ The basis, as defined by Fama and French (1987), is the spread between the current futures and spot price.

² A regression of the realized change in the spot price on the lagged observation of the basis.

³ These models reject the null hypothesis that the basis does not predict movement in the spot price, but produce a low R².

⁴ It is important to note that since both the spot and futures prices are known, these represent risk-free transactions; see Pindyck (1993).

⁵ A notable exception is Moosa and Al-Loughani (1995).

⁶ This convention is generally attributed to Andrews (1993).