Gauge Invariance, Geometry and Arbitrage: Samuel E. Vázquez

The Journal of Investment Strategies (23–66) Volume 1/Number 2, Spring 2012
Gauge invariance, geometry and arbitrage

Samuel E. Vázquez
Capital Fund Management S.A., 6 Boulevard Haussmann, 75009 Paris, France;
email: [email protected]
Simone Farinelli
Kraus Partner Investment Solutions AG, Militärstrasse 76, 8004 Zurich,
Switzerland; email: [email protected]
We identify the most general measure of arbitrage for any market model governed
by Ito processes, and, on that basis, we develop dynamic arbitrage strategies.
It is shown that our arbitrage measure is invariant under changes of numeraire
and equivalent probability measure. Moreover, such a measure has a geometrical
interpretation as a gauge connection. The connection has zero curvature if and
only if there is no arbitrage. We prove an extension of the martingale pricing
theorem in the case of arbitrage. In our case, the present value of any traded asset
is given by the expectation of future cashflows discounted by a line integral of the
gauge connection. We develop simple dynamic strategies to measure arbitrage
using both simulated and real market data. We find that, within our limited data
sample, the market is efficient at time horizons of one day or longer. However, we
provide strong evidence for nonzero arbitrage in high-frequency intraday data.
Such events seem to have a decay time of the order of one minute.
1 INTRODUCTION
The no-arbitrage principle is the cornerstone of modern financial mathematics. Put
simply, an arbitrage opportunity allows an agent to make a risk-free profit with zero
or negative net investment (see Delbaen and Schachermayer (2008)). Under the no-
arbitrage assumption we can assign, in a complete market, a unique price to the
derivative of any traded assets using the replicating portfolio method (see Musiela
and Rutkowski (2007) or Cvitanic and Zapatero (2004)). The no-arbitrage principle
We would like to extend our gratitude to Eric Weinstein, Pia Malaney, Lee Smolin, Bernd Schroers,
Mike Brown, Simone Severini, Jiri Hoogland, Jim Herriot and Bruce Sawhill for many discussions
and ideas that influenced the results of this paper. The opinions expressed in this paper are the
authors’ own and do not represent those of Capital Fund Management S.A. or of Kraus Partner
Investment Solutions AG. The risk control principles presented are not necessarily used by Capital
Fund Management S.A. or by Kraus Partner Investment Solutions AG. This document does not
provide a comprehensive description of concepts and methods used in risk control at Capital Fund
Management S.A. or at Kraus Partner Investment Solutions AG.
23
24 S. E. Vázquez and S. Farinelli
can also be shown to be equivalent to a weaker form of economic equilibrium (see

Cvitanic and Zapatero (2004)) and can therefore be seen as a form of market efficiency
(see Fama (1998) and Malkiel (2003)). It is, then, not surprising that most financial
and economic literature is based on the no-arbitrage assumption.
Nevertheless, the no-arbitrage principle represents a very strong assumption about
market dynamics that must be tested empirically. Even when the market participants
use no-arbitrage models, the ultimate price of any security that is traded in a centralized
market is set by supply/demand and the complex dynamics of the order book. That
is, the market sets the prices. It then makes sense to ask: how efficient are these final
prices? In order to answer this question we need a measure of arbitrage.
There is a large body of empirical literature on financial arbitrage. Most of these
studies focus on measuring the excess return of particular trading strategies (see, for
example, Jegadeesh and Titman (1993) and Gatev et al (2006)). Other studies try
to find violations of general no-arbitrage relations between option prices (see, for
example, Ackert and Tian (1999)). However, there does not seem to be a consensus
on whether the reported market “anomalies” are due to arbitrage, or simply to random
fluctuations (see Malkiel (2003) and Fama (1998)). Part of the problem is that there
seems to be no general measure of arbitrage that can be applied to any traded asset.
One of the main goals of this paper is to define such a measure.
The second goal of this paper is to provide a geometrical interpretation of the
arbitrage measure. In particular, it was speculated long ago by Ilinski (1997, 2001)
and Young (1999) that arbitrage should be viewed as the “curvature” of a gauge
connection, in an analogy to some physical theories. The fact that gauge theories are
the natural language for describing economics was first proposed by Malaney (1996)
and Weinstein (2006) in the context of the economic index problem. The need for
such mathematical language can easily be seen from the fact that prices are only
relational. More precisely, let X.t / D .X1 .t /; X2 .t /; : : : / be the price vector of all
goods in the economy at time t , in some common unit (US dollars, say). Since the
measuring units are arbitrary, fundamental economic laws must be invariant under
the transformations:
X.t / ! .t /X.t / (1.1)
where .t/ > 0 is a positive stochastic factor.1 In physics, a (local) transforma-
tion such as Equation (1.1) is known as a gauge transformation. These represent a
redundancy in our description of the economic system. The laws of the economy
should be gauge invariant. The need for a gauge-theoretical approach to economics
was highlighted recently by Smolin (2009). The role of gauge invariance in option
pricing has been studied in Hoogland and Neumann (1999a,b, 2000) and in Hoogland
1 For example, .t/ can be the euro–US dollar exchange rate.
The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

Gauge invariance, geometry and arbitrage 25
et al (2001). For an unrelated use of differential geometric methods in (no-arbitrage)

option pricing, see Labordère (2008). A recently introduced alternative definition of
the gauge connection (Farinelli (2011)) can be shown to lead to an arbitrage measure
equivalent to ours.
In physics, curvature is a gauge-invariant measure of the path dependency of some
physical process. For example, readers familiar with electrodynamics might recall
the vector potential A , where D 0; 1; 2; 3 label the space and time directions. In
differential geometry for theoretical physics, A is known as a gauge connection. Now
consider a charged particle that is traveling along some trajectory in space-time x .s/,
s 2 Œ0; 1. The interaction of this particle with the gauge potential is proportional to
the line integral:
Z XZ 1
A WD A .x.s//xP .s/ ds
0
Now suppose that we make an infinitesimal change in the path of the particle ıx .s/,
keeping the boundary conditions fixed ıx .0/ D ıx .1/ D 0. The interaction
changes by:
Z XZ 1
ı A D ıx .s/xP .s/F
; 0
where F D @ A @ A is known as the curvature of A. Therefore, we see

R
that, for zero curvature F D 0, the line integral A is independent of the path
. Moreover, note that the curvature is invariant under a gauge transformation of the
form A ! A C @ , where is any function of space-time.
We find a very similar construction in the case of mathematical finance. In par-
ticular, we show that the arbitrage curvature defined in this paper measures the path
dependency of the present value of a self-financing portfolio of traded assets with
fixed final payoff. The no-arbitrage principle is then equivalent to a zero-curvature
condition. By analogy with the electromagnetic curvature F , we expect that any mea-
sure of arbitrage should be invariant under the gauge transformation in Equation (1.1).
Moreover, the fundamental theorem of asset pricing states that the no-arbitrage princi-
ple is equivalent to the existence of a probability measure with respect to which asset
prices expressed in terms of a numeraire are martingales (Musiela and Rutkowski
(2007)). Therefore, we expect that any measure of arbitrage should also be invariant
under a change of probability. These are, in fact, two very important properties that
will characterize our arbitrage measure.
This paper takes a “macroscopic” or phenomenological approach to arbitrage.
More precisely, we will study arbitrage from the point of view of general stochastic
models. We do not address the question of what is causing the arbitrage. Our main
goal is to identify the gauge-invariant financial observables that indicate an arbitrage
Research Paper www.thejournalofinvestmentstrategies.com

opportunity. Our main assumption is that the prices of all financial instruments can
be described by Ito processes. Moreover, we ignore transaction costs.2
The organization and main results of the paper are as follows. In Section 2 we
present the class of models that we use in the rest of the paper. They are very gen-
eral and include the case of stocks, bonds and commodities, and more complicated
derivative products. We decompose the dynamics of these models in terms of their
gauge-transformation properties with respect to Equation (1.1). We identify the gauge
invariants and show that they represent an obstruction to the existence of a martingale
probability measure. We conclude Section 2 with an example with three assets, and
we derive a modified nonlinear Black–Scholes equation with arbitrage.
In Section 3 we give a geometrical interpretation to the gauge-invariant quantities
defined in Section 2. Our main goal is to identify the stochastic gauge invariants of
Section 2 with the curvature of a gauge connection. We begin with a review of the
Malaney–Weinstein connection (Malaney (1996) and Weinstein (2006)), which is
done in the context of differentiable economic paths. In Section 3.1 we generalize the
Malaney–Weinstein construction to stochastic processes and prove an asset pricing
theorem. The main result of this section is that the present value of any self-financing
portfolio of traded assets is given by the conditional expectation of future cashflows,
discounted by a line integral of the Malaney–Weinstein gauge connection. We show
how the value functions of different portfolios replicating the same contingent claim
are related to the arbitrage curvature. Readers who are interested only in the arbitrage
measure and the detection techniques can skip Section 3.
In Section 4 we develop a simple algorithm to measure the arbitrage curvature
using financial data. None of the results of Section 4 require an understanding of the
geometry of arbitrage. We explain the main sources of error in such measurement. The
algorithm is applicable to any financial instrument. In Section 5 we provide examples
with financial data of stock indexes and index futures and construct dynamic arbitrage
strategies. We find that, on long timescales, the market is very efficient. However, we
provide strong evidence for nonzero-curvature fluctuations at short timescales of the
order of one minute. We conclude in Section 6.
2 STOCHASTIC MODELS AND GAUGE INVARIANCE

Let M D f0; 1; 2; : : : ; N 1g be the set of all traded securities at any point in time in
the market. We will use Greek indexes ; ; : : : to label members of the set M. We
denote the price of security 2 M by X . Our main assumption is that the dynamics
2 Note that, as pointed out in Shleifer and Vishny (1997), many possible arbitrage opportunities
disappear once we take into account market frictions such as transaction costs. Therefore, it is
important to keep in mind that, even when we measure a nontrivial curvature in the market, it does
not mean that it can always be exploited in a practical trading strategy.

of all such securities is described by Ito processes of the form (see Sondermann (2006)
and Shreve (2000)):
X
dX WD X ˛ dt C a dWa ; 8 2 M (2.1)
a
where the Wa are standard Brownian motions such that the Wa .t / Wa .0/ are inde-
pendently and normally distributed random variables with:
EŒWa .t/ Wa .0/ D 0; covŒWa .t / Wa .0/; Wb .t / Wb .0/ D t ıab (2.2)
We make no assumptions about the number of Brownian terms, and hence the
completeness of the market. The set of Brownian motions fWa g represents all the
randomness in the market. Therefore, they induce a natural filtration F D .F t / t >0
for our probability space. The coefficients ˛ and a can also be stochastic processes
adapted3 to the filtration F . However, they are assumed to satisfy suitable conditions
to ensure the existence of the price processes X (see Lamberton and Lapeyre (2007)).
This class of models is very general and includes stocks, bonds, options, etc. Moreover,
the case of fat tails in the distribution of returns is also included, since this is known
to be generated by stochastic volatilities a .
Looking back at Equation (2.1), we can see that the tangent space dX has a natural
P
decomposition into the directions that contain all the randomness ( a a dWa ) and
those orthogonal to it. Therefore, we will make the following decomposition of the
drift term in Equation (2.1):
X X
˛ D ˛ C ˇ a O a C ˛ A JA (2.3)
a A2N
where N is the space spanned by basis vectors J A WD ŒJ0A ; : : : ; JNA1 such that:
X 9
JA JB D ı AB >
>
>
>
>
>
X >
=
JA D 0 (2.4)
>
>
X >
>
>
JA a D 0; 8a>
>
;

3In simple terms, a process p adapted to F means that it does not depend on future values of the
Brownian motion. In other words, p.t/ can only depend on fWa .s/g up to time s 6 t.

and: 9
1 X >
˛ WD ˛ >
>
N >
>
>
>
X >
>
>
A
˛ WD J ˛ >
A >
=
(2.5)
>
>
O a
WD >
a >
>
a
>
>
1 X >
>
a>
a
WD >
>
;
N
We will refer to N as the null space of the market. Note that this space is orthogonal
to all the randomness in the tangent space dX . However, we need to remember that
N might be trivial. The definition of ˇ a in Equation (2.3) is not unique if the vectors
O a WD ŒO 0a ; : : : ; O N
a
1 are linearly dependent. This is the case of, for example, an
incomplete market with more Brownian motions than traded securities. Moreover,
˛ A is unique up to rotations in the null space. As we will see, the quantities ˛ A are
the unique gauge-invariant measures of arbitrage. The two main goals of this paper
are to give a geometric interpretation to the parameters ˛ A , and to set up a procedure
to measure them using financial data.
Since prices are relative and only reflect an exchange rate between two products,
the units used to measure X are arbitrary. Therefore, the dynamics of the market
must be invariant under a change of measuring units. In mathematical finance, this
is known as a change of numeraire Musiela and Rutkowski (2007), and it can be
interpreted as a gauge transformation:
X .t / ! .t /X .t / (2.6)
where is a positive stochastic process that is adapted to the filtration F . Another

symmetry, which is special to the particular models of Equation (2.1), is a transforma-
tion of the probability measure. This is not really a gauge symmetry, but corresponds
rather to a change of variables of the form:
Z t
Wa .t/ ! Wa .t / C ıˇ a .s/ ds
Our next task is to study the transformation properties of the different terms in
Equations (2.1) and (2.3). The following result follows.
Proposition 2.1 Consider a change of numeraire of the form X ! X , where
is a positive stochastic process adapted to the filtration F and:
X
a
d WD ı˛ dt C ı dWa
a

Then, the coefficients of the Ito processes, Equations (2.1) and (2.3), transform as:
X 9
˛ ! ˛ C ı˛ C a ı a >
>
>
=
a
a a
ˇ ! ˇ C ı a (2.7)
>
>
>
;
a ! a C ı a
Finally, under a transformation of the probability measure given by the Radon–

Nykodým derivative:
Z tX Z tX
dP a 1 a 2
D exp ıˇ dWa .ıˇ .s// ds
dP a
2
a
we have the mapping of standard Brownian motions:

Z t
Wa .t/ ! Wa .t / C ıˇ a .s/ ds (2.8)
and: X
˛!˛C a ıˇ a ; ˇ a ! ˇ a C ıˇ a (2.9)
a
In particular, it follows that O a , ˛ A and JA are invariant under such transformations.
Proof The result in Equation (2.7) above follows from a simple application of Ito’s
rule to the product X0 WD X :
dX0 D dX C dX C dh; X i

X X X
0 a a a a a A A
D X ˛ C ı˛ C ı C .ˇ C ı /O C ˛ J dt
a a A2N
X
C .O a a a
C C ı / dWa
a
(2.10)
P
where dh; X i D dtX a ı a a is the differential of the quadratic variation.
The transformation in Equation (2.9) follows from a simple differentiation of Wa in
Equation (2.1):
X X X
a a a a a A A
dX D X ˛ C ıˇ C .ˇ C ıˇ /O C ˛ J dt
a a A2N
X
a a
C .O C / dWa (2.11)
a

where we defined: Z t
Wa .t/ D Wa .t / C ıˇ a .s/ ds
Note that both ˛ A and J A are unchanged by these gauge transformations. In particular,
suppose that: X
JA a D 0

Then, it follows from Equation (2.4) that:

X X
JA .a C ı a / D JA a D 0

So far we have taken the existence of the basis vectors J A for granted.A constructive
procedure to find such a basis, if nontrivial, is given by the following proposition.
Proposition 2.2 Let ˝ be the symmetric and real N N matrix with component:
X
˝ D a a ; where N D dim.M/
a
Moreover, define U as the matrix of all ones, eg, U D 1; 8; 2 M. Then, the
matrix G defined as:
1 1
GD˝ .U ˝ C ˝U / C 2 Tr.U ˝/U (2.12)
N N
P
is gauge invariant. Let NG be the null space of matrix G such that J D 0 for any
nontrivial J 2 NG . Then NG D N . In particular, the space NG is spanned by the
orthonormal zero modes of G that are orthogonal to the vector J D .1; 1; : : : ; 1/ .
Proof First we need to prove that the space of vectors J such that J a D 0; 8a,
is in one-to-one correspondence with the zero modes of ˝: ˝J D 0. Obviously, if
J a D 0, it follows that J is also a zero mode of ˝. To prove the converse, suppose
that ˝J D 0, but J a D a , where a ¤ 0 for at least one value of a. Then:
X
0 D J ˝J D .a /2
a
which can only be true if a D 0; 8a.

Now we turn our attention to the matrix G, defined in Equation (2.12). Using the
gauge transformation a ! a C ı a , we can see that ˝ transforms as:
X X
˝ ! ˝ C ı a .a C a / C .ı a /2 (2.13)
a a

It is then straightforward to verify the gauge invariance of the matrix G. Next we

recall that the space N is spanned by (nontrivial) orthonormal zero modes of ˝ such
P
that they also satisfy J D 0. One can define a similar space NG for G. It is
easy to verify that any vector J 2 N is also a vector in NG . On the other hand, for
any vector J 0 2 NG , it follows from Equation (2.12) that ˝J 0 D 0. Thus, we have
proven that N D NG .
P
It is easy to verify that G D 0. Therefore, the vector J D .1; 1; : : : ; 1/ is a
particular zero mode of G. Now take any other zero mode of G, and call it J 0 , which
P
is orthogonal to J . It follows that 0 D J J 0 D J0 . Therefore, J 0 2 NG D N .
This completes the proof.
So far we have talked about the full set of securities of the market. However, it
is clear that the decomposition in Equation (2.3) can be done for any subset of the
market. That is, suppose we observe a subset of the prices Xi , i 2 S M. Moreover,
suppose that, within this subset, we can still find some zero modes J A obeying:
X X
JiA ia D 0; 8a; JiA D 0
i i
A
We can then easily lift these vectors to the full set M by taking JM D .J A ; 0/. This
represents a particular choice of basis in the null space N . By observing a subsector of
the market, we will only have access to some of the components of ˛ A . For notational
convenience, in the following we will not distinguish between the full market and a
subset of it.
In a next step we want to link ˛ A with the no-arbitrage condition. But what do
we mean exactly by “no-arbitrage condition”? As a matter of fact there exist two
similar conditions, the no-arbitrage condition and the no-free-lunch-with-vanishing-
risk condition (NFLVR) (see Delbaen and Schachermayer (2008)), which, in discrete
time, are equivalent. In continuous time NFLVR is the stronger condition and is
equivalent to the existence of a martingale measure for the (discounted) asset prices
(see Delbaen and Schachermayer (2008, Chapter 9.4)).
Under the NFLVR assumption (see Delbaen and Schachermayer (2008) and Hunt
and Kennedy (2004)), it is always possible to find a common positive discount factor
and an equivalent probability measure P P such that the discounted prices X
are martingales .t/X .t/ D Et Œ.T /X .T /, where t 6 T . This is known as
the martingale representation theorem (see Sondermann (2006) and Shreve (2000)).
In our language, this means that there is a gauge transformation mapping X to
P -martingales. In other words, if there is no arbitrage, price processes are gauge
equivalent to P -martingales for some probability measure P . The result of the

martingale representation theorem can only be obtained if one is able to write:

Z T Z T
d.X / WD a dWa
t t
RT
for some adapted process a . The reason is that the stochastic integral t a dWa is
a martingale:
Z T
Et a
dWa D 0
t
By Proposition 2.2, there is neither a change of probability nor a choice of a positive

P
discount factor for which the vector A2N ˛ A J A is mapped to 0 (in contrast to ˛
and all ˇ a , which can indeed be made to vanish). Therefore, it is easy to see that
P
the term A2N ˛ A J A parameterizes the obstruction to the existence of a martingale
probability measure for any discounted price process X . Its vanishing is a necessary
but not sufficient condition for the existence of an equivalent martingale measure.
As ˛ A are gauge-invariant quantities, one expects that they should be observables.
In the next section we will relate this quantity to a gauge connection and its curvature.
In Section 4 we show that such a quantity can indeed be observed, and we explain
simple strategies to measure it. Before concluding this section, it is instructive to
study a particular example with three assets.
2.1 An example
Consider the case of three assets X , D 0; 1; 2, where X0 is a savings account and
X1 , X2 are some other risky assets. All prices are measured in the same common
units. We will assume only one Brownian motion. Therefore, the dynamics of the
prices are described by:
)
dX0 D rX0 dt
(2.14)
dXi D Xi Œ˛i dt C i dW ; i D 1; 2
For later convenience, we assume that the interest rate r is deterministic. In order
to carry out the decomposition in Equation (2.3) we need to find a basis for the null
space N . In this case, since there is only one Brownian motion and two risky assets,
there will be only one null direction. To calculate it, we start by identifying the ˝
matrix:
0 1
0 0 0
B C
˝ D @0 12 1 2 A (2.15)
0 1 2 22

We can now construct the G matrix using Equation (2.12). The explicit form of G is
not very illuminating. The unnormalized eigenvectors of G are found to be:
0 C 1
0 1 0 1 1 2
31 31
2 1 C B 1 22 C
B 1 C 2 C B 1 C 2 C B C
B C B C B C
V1 D B C; V2 D B C; V3 D B 2 21 C
@ 0 A @ 1 A B C
@ 1 22 A
0 0
1
(2.16)
where: 9
GV1 D 0 >
=
GV2 D 0 (2.17)
>
;
2 2 2
GV3 D 3 .1 C 2 1 2 /V3
In order to find a basis for the null space N defined in Equation (2.4), we need to
project V1 or V2 into the space orthogonal to the vector J 0 D .1; 1; : : : ; 1/ . To do
this, we define the projection matrix:
PU WD 13 U; PU2 D PU (2.18)
where U is the 33 all-ones matrix. Note that 1PU projects into the space orthogonal
to J 0 . Our choice for the normalized null vector is then:
0 1
1 2
.1 PU /V1 1 B C
J Dp Dp p @ 2 A (2.19)

Œ.1 PU /V1 .1 PU /V1 2 2
2 1 C 2 1 2 1
It is easy to verify that J obeys the properties given in Equation (2.4).

We can now go back to the decomposition given in Equation (2.3). Using Equa-
tion (2.14), we find:
˛ D r ˇ O 0 ˛J
Q 0 ; 0 D 0 (2.20)
P
where O D 13 2D0 , and ˛Q is the arbitrage vector ˛ A , which in this case
has only one component ˛ 1 WD ˛. Q Therefore, inserting Equation (2.20) into Equa-
tion (2.14), we can write the evolution equations as:
dX0 D rX0 dt (2.21)

22 1
dX1 D X1 r C ˇ1 C ˛Q p p dt C 1 dW (2.22)
2 12 C 22 1 2

2 21
dX2 D X2 r C ˇ2 C ˛Q p p dt C 2 dW (2.23)
2 12 C 22 1 2

For ˛Q D 0, Equations (2.21)–(2.23) reduce to the familiar no-arbitrage Black–Scholes

dynamics. As usual, ˇ is interpreted as the market price of risk. Note that, in this
example, both risky assets are exposed to the same market risk factor W . The volatility
i measures the coupling to such risk. Under the no-arbitrage assumption, both assets
should give the same expected return per unit of risk. This is ˇ. However, we see that
if ˛Q ¤ 0, X1 and X2 have different expected returns, even when they are exposed to
the same risk. This discloses an arbitrage opportunity.
There is a very interesting consequence of Equations (2.21)–(2.23) when X2 is
any function of X1 (eg, an option). For simplicity, consider the case where the only
time dependence in ˛Q is of the form ˛Q D ˛.t;
Q X1 /, where ˛.t;
Q X1 / is a differentiable
function of t and X1 . Moreover, the interest rate r is assumed to be deterministic.
In this case we can derive a nonlinear version of the Black–Scholes equation with
arbitrage. For ease of notation, let X1 WD X. Under our assumptions we will have
that X2 D V .t; X/. Then, using Ito’s rule, we find:
2
dV D @ t V dt C @X V dX C 12 @X V dhXi
D V .˛2 dt C 2 dW / (2.24)
where we identify:
9
@t V @X V @2 V >
>
˛2 D C ˛1 X C 12 12 X 2 X =
V V V (2.25)
@X V >
>
2 D 1 X ;
V
Comparing Equation (2.25) with Equation (2.23), we find that:
2 21
˛2 D r C ˇ2 C ˛Q p p
2 12 C 22 1 2
@t V @X V @2 V
D C ˛1 X C 12 12 X 2 X (2.26)
V V V
where, from Equation (2.22):
22 1
˛1 D r C ˇ1 C ˛Q p p (2.27)
2 12 C 22 1 2
Therefore, after some algebra, Equation (2.26) becomes a modified nonlinear Black–
Scholes partial differential equation:
@ t V C rX@X V C 12 12 X 2 @X
2
V
1=2
p X @X V X @X V
C 2˛Q 1 C 1 r V D 0 (2.28)
V V

Note that, for ˛Q D 0, this reduces to the familiar Black–Scholes equation. The non-
linear Black–Scholes equation is a special case of the more general pricing theorem
presented in Section 3.
It is important to remember that the arbitrage parameter ˛Q in Equation (2.28) can
in general depend on time and the stock price. Therefore, in principle, almost any
deformation of the option price is possible. It follows that Equation (2.28) can be
solved only if the arbitrage dynamics are known. For example, consider the case
where we set:
2
1 X 2 @X V
˛Q WD 3=2
.Q 12 12 / (2.29)
2 V Œ1 C .X @X V =V /..X @X V =V / 1/1=2
for some constant Q 12 . Then, the option price obeys the usual Black–Scholes equation
but with the “wrong” volatility:
@ t V C r.X@X V V / C 12 Q 12 X 2 @X
2
V D0 (2.30)
This is a simple example of the well-known volatility arbitrage.
3 THE GAUGE CONNECTION

The application of differential geometric ideas in economics can be traced to the
work of Malaney (1996) and Weinstein (2006). It was found that the solution to the
apparent discrepancy among different economic growth indexes could be solved by
the appropriate choice of a covariant derivative. Such a derivative has the property
that a self-financing basket of goods is seen as “constant”. More technically, a self-
financing basket is interpreted as being “parallel transported” along a one-dimensional
curve in the base manifold spanned by prices and portfolio nominals. Then there is
a natural geometric index to measure the growth of such basket, which was shown
to be identical to the so-called Divisa index. It is very illuminating to review this
construction to gain intuition about the relation between arbitrage and curvature. In
what follows, all quantities are assumed to be deterministic and differentiable. We
will return to the stochastic case in the next subsection.
A covariant derivative induces a connection one-form in the base space (for the
differential geometric background see Kobayashi and Nomizu (1996) and Bleecker
(1981)). In Malaney (1996) and Weinstein (2006), this connection is given by:
P
dX
AD P (3.1)
X
P
where are the portfolio nominals, V D X , and the base space is param-
eterized by the coordinates .t; ; X /. Note that under a change of numeraire

X ! .X/X , the connection transforms as:
A ! A C d (3.2)
This is the analog of the transformation rule of the vector potential in electrodynamics.
A self-financing portfolio can be seen as being parallel transported with the con-
nection A as:
rP V D .d A/V jP D 0 (3.3)
where rP is the covariant derivative along the trajectory . The solution to this equa-
tion is simply: Z
V .T /
D exp A WD D (3.4)
V .t /
where is a particular self-financing trajectory .s; .s/; X.s//, s 2 Œt; T , and D is

known as the Divisa index.
The dependence of D on the choice of curve is parameterized by the curvature
of the gauge connection, which is given by:
1 X
R D dA D P . X d ^ dX X d ^ dX / (3.5)
. X /2 ;
Note that the curvature is invariant under a gauge transformation, as d.ACd/ D dA.
In the approximation where economic agents are price takers, the price trajectory
X.t / is given exogenously, and we are only allowed to make changes in the portfolio
nominals . In other words, we can write dX D XP dt in Equation (3.5). We can
then restrict the curvature to the submanifold corresponding to the .t; / coordinates.
The induced curvature in this submanifold is given by:
X P
1 X XP
R D P X X
d ^ dt
. X /2 ; X X
X
WD R;t d ^ dt (3.6)

In this case, the path dependency of the Divisa index, Equation (3.4), can be written
as:
XZ T
ı log D D ds R;t .s/ı .s/ (3.7)
t
where ı represents a variation to the trajectory of the portfolio nominals. Therefore,

we see that Equation (3.4) is independent of the path only if the price trajectories
obey the zero-curvature condition:
R;t D 0 H) XP .t / D ˛.t /X .t /; 8

The zero-curvature condition implies that the prices of all securities evolve by the
same common inflation factor.
The relation between curvature and arbitrage goes as follows. Suppose that the
prices obey the zero-curvature condition given above. It follows that, for any self-
financing portfolio, we have:
Z
V .T / D V .t / exp A

Z T
D V .t / exp ˛.s/ ds (3.8)
t
for T > t . In particular, if V .t/ D 0, it follows that V .T / D 0. Therefore, it is

not possible to make wealth without a positive initial investment. On the other hand,
suppose that the curvature is not zero. Consider two portfolio trajectories 1 and 2
such that, say, D1 > D2 at some time T > t , for the same initial wealth V1 .t / D
V2 .t/ > 0. Now construct the difference portfolio with nominals WD 1 2 and
wealth function:
V D V1 V2 (3.9)
Then, at time T > t we have:
V .T / D .D1 D2 /V1 .t / > 0 (3.10)
while V .t / D 0. In other words, we have made wealth out of nothing. In the next
section we show how this construction carries over to the stochastic case.
3.1 The stochastic gauge connection

In the previous section we illustrated the relation between curvature, path dependency
and arbitrage, using the Malaney–Weinstein connection. However, this construction
only works for differentiable economic trajectories in the base space .; X /. Never-
theless, we have found a direct analog of the Malaney–Weinstein connection for Ito
processes, which we summarize in the following theorem. In order to avoid technical
complications, we restrict our attention to an economy on a finite interval of time
t 2 Œ0; T .
P
Theorem 3.1 Consider any self-financing portfolio V D X , so that:
X
dV D dX

Then, if there exists a change of measure satisfying the Novikov condition, then there
exists a (nonunique) equivalent probability measure P P under which the price

processes obey:
X X
dX D X ˛ C ˛ A JA dt C a dWa (3.11)
A a
Moreover, the present value of V .t / given some final payoff V .T /, T > t , is given by:
Z
V .t/ D Et V .T / exp (3.12)

where is some self-financing trajectory, and is given by the expectation of the

Malaney–Weinstein connection:
P P A A
dX ;A2N ˛ J X
D Et P

D P dt C ˛ dt (3.13)
X X
Finally, the path dependency of the present value of the portfolio, with fixed final
payoff, is parameterized by:
XZ T Z
ıV .t/ D ds E t V .T / exp ı .s/R;t .s/

(3.14)
t
where R;t are the components of the curvature two-form defined in the reduced base
space .t; /:
R D d
1 X
D P 2
˛ A X X .JA JA / d ^ dt
. X /
;;A2N
X
WD R;t d ^ dt (3.15)

Proof We start by writing the portfolio return as:

X X
dV D dX WD V a dt C b a dWa (3.16)
a
where: P P
˛ X a a X
aD P ; b D P (3.17)
X X
Now consider the combination V 0 WD V , where we take (see Equation (2.1)):
X X
a a a
d D a C b ˇ dt ˇ dWa (3.18)
a a

A simple application of Ito’s rule gives:

X
dV 0 D V 0 .b a ˇ a / dWa (3.19)
a
Rt
It is well-known that any stochastic integral of the form 0 dWa is a martingale (see
Sondermann (2006) and Shreve (2000)). Therefore, we have:
Z T
V .t / D E t V .T / exp d log (3.20)
t
A further application of Ito’s rule gives:
1X a 2 X
d log D .ˇ / dt ˇ a dWa (3.21)
2
a a
P
where is defined in Equation (3.13), with ˛ WD ˛ a ˇ a a .
Now consider making a change of probability measure such that:
Z t
Wa WD Wa ˇ a .s/ ds
It is easy to see that, under P , the price processes will obey Equation (3.11) of the
theorem. Moreover, the Radon–Nykodým derivative is given by:
Z T XZ T
dP 1X a 2 a
D exp .ˇ .s// ds C ˇ dWa (3.22)
dP 2
a t a t
This Radon–Nykodým derivative is a martingale if the Novikov condition:

Z
T
1 X
E exp .ˇa /2 ds < C1 (3.23)
0 2 a
is satisfied. Therefore, using Equations (3.21) and (3.22) in (3.20), we obtain:

Z Z T XZ T
1X
V .t / D E t V .T / exp a 2
.ˇ / dt ˇ a dWa
2 t t
a a
Z Z T XZ T
dP 1X
D Et V .T / exp C .ˇ a /2 dt ˇ a dWa
dP 2 t t
a a
Z
D Et V .T / exp (3.24)


In order to prove that can be written as an expectation of the Malaney–Weinstein

connection, we recall that:
X .t/X .t / X
A A
D P ˛ C ˛ J dt
.t/X .t / A2N
X
.t / E t ŒX .t C ıt / X .t /
D lim P dt
ı t!0
.t /X .t / ıt
X
.t / X .t C ıt / X .t /
D lim Et P dt
ı t!0
.t /X .t / ıt
P
dX
D Et P
(3.25)
X
The last result of the theorem, Equation (3.14), follows simply by making a small
change in the portfolio nominals, and keeping the boundary conditions on V fixed.
Note that the curvature of is zero if and only if ˛ A D 0, which implies, together
with the Novikov condition, the no-arbitrage condition. Moreover, the probability
measure P might not be unique, as the choice of ˇ a in general is not. This also
implies that ˛ is not unique in general.
A special case of a self-financing portfolio is a portfolio containing just one base
asset.
Corollary 3.2 Under the same assumptions as Theorem 3.1, for all assets in the
market model 2 M:
Z T X
X .t/ D E t X .T / exp

˛ C ˛ J dt 0
A A
(3.26)
t A
In particular, under the no-arbitrage assumption ˛ A D 0, we recover the classic

martingale pricing theorem:
Z T
X .t/ D Et X .T / exp ˛ dt 0 (3.27)
t
In Section 2.1 we derived a modified Black–Scholes equation for the case of three
assets. Now we can use the result of Corollary 3.2 to prove a generalization of such
an equation. Consider the following vector of assets:
X D ŒX0 ; X1 ; : : : ; Xn ; ˚1 .X ; t/; : : : ; ˚m .X ; t / (3.28)
We will label the components of this vector by X , D 0; 1; : : : ; n C m. Moreover,

we assume that the ˚i are smooth functions of the vector of underlying prices, X WD

ŒX1 ; : : : ; Xn , and dX0 D X0 r dt describes a savings account with deterministic

interest rate r. The functions ˚i .X ; t/ describe a set of European-style contingent
claims with final payoff ˚i .X .T /; T / D fi .X .T //, for some fixed T > t . Finally,
we need to assume that ˛ A are either deterministic or some function of the underlying
prices X . These assumptions ensure that the expectation values in the right-hand side
of Equation (3.26) are functions of X and t only, and so our assumption, ˚i D
˚i .X ; t /, is self-consistent. Under these assumptions we can prove the following
corollary.
Corollary 3.3 (Modified Black–Scholes equation) Under the assumptions given
above, Corollary 3.2 implies that the European-style contingent claims ˚i , i D
1; : : : ; m, obey the nonlinear Black–Scholes equations:
n
X X X
A
@ t ˚i C ˛ C ˛ JjA Xj @j ˚i ˛ C
˛ A A
JnCi ˚i
j D1 A A
n
1 X
C ˝j k Xj Xk @j @k ˚i D 0 (3.29)
2
j;kD1
with terminal conditions ˚i .X ; T / D fi .X /. Moreover, the J A D J A .X ; t/ are a

basis for the null space N of the .nCmC1/.nCmC1/ matrix ˝ with components
P
˝ D a a a , where the ia , i D 1; : : : ; n, are the volatilities of the underlying
securities, and we define 0a WD 0:
n
X
a
nCi WD ja Xj @j log ˚i .X ; t /; i D 1; : : : ; m (3.30)
j D1
and: X
˛ D r ˛ A J0A (3.31)
A
Proof Equation (3.29) of Corollary 3.3 is a simple application of the Feynman–Kac

theorem to Equation (3.26) (see Shreve (2000)). In order to calculate all components
of the matrix ˝, we remind the reader that the underlying prices X obey:
X X
A A a
dXi D Xi ˛ C ˛ Ji dt C i dWa ; i D 1; : : : ; n (3.32)
A a
This implies that the stochastic part of d˚i is given by:

n
X
d˚i .X ; t / D ˚i .X ; t/ Xj @j log ˚i .X ; t /ja dWa C (3.33)
j D1

Therefore, the volatilities for the XnCi D ˚i securities are:

n
X
a
nCi D ja Xj @j log ˚i .X ; t/ (3.34)
j D1
Moreover, since X0 is a deterministic process, it follows that 0a D 0. In order

to prove Equation (3.31) of the corollary, we recall that the savings account obeys
P
dX0 D rX0 dt . This implies that r D ˛ C A ˛ A J0A . This completes the proof.
The example of Section 2.1 is a special case of Corollary 3.3, with n D m D 1. In

this case there is only one null direction. We will use the notation X1 WD X, ˚1 WD V ,
11 WD 1 and ˛ 1 WD ˛Q in what follows. A choice for the basis of the null space was
given in Equation (2.19), which we repeat here for the convenience of the reader:
0 1
1 X @X log V
1 B C
J Dp p @ X @X log V A (3.35)
2 1 C X@X log V .X @X log V 1/
1
It follows that Equation (3.29) becomes:
0 D @ t V C .˛ C ˛J
Q 1 /X@X V .˛ C ˛J
Q 2 /V C 12 12 X 2 @X
2
V
D @ t V C .r C ˛.J Q 2 J0 //V C 12 12 X 2 @X
Q 1 J0 //X @X V .r C ˛.J 2
V
D @ t V C r.X@XV V / C 12 12 X 2 @X
2
V
p p
C 2˛V Q 1 C X @X log V .X @X log V 1/ (3.36)
This is exactly what we obtained in Section 2.1 (see Equation (2.28)).
4 MEASURING ARBITRAGE CURVATURE

In this section we explain how to estimate the arbitrage parameters ˛ A using financial
data. Given the discussion in the previous section, measuring these parameters is
equivalent to measuring the “curvature” of the market. Needless to say, we can do
this for a subset of all instruments only, and there are many technical difficulties,
which we discuss below.
Even though ˛ A is a gauge invariant, it is still defined up to a rotation in the null
space4 N . Therefore, the basic idea is to measure the rotational and gauge-invariant
quantity:
X ˛ A JA dX X
D .˛ A /2 > 0 (4.1)
X dt
;A A
4For notational simplicity, we will still use N for the null space of the particular market subsector
under study. However, it is important to keep in mind that this is not the null space of the full market.

where ˛ A in the left-hand side of this equation is expressed as:
X JA dX
˛A D (4.2)

X dt
The vectors J A must be calculated using an estimate for the quadratic variation:
dhlog X ; log X i
˝ WD
dt
and the results of Proposition 2.2. We introduce the notation:
X
A2 WD .˛ A /2
A
for the measurement of arbitrage curvature. A positive detection of A2 can be trans-

lated into a self-financing arbitrage portfolio strategy using the result of the following
proposition.
Proposition 4.1 (Arbitrage strategy) Let the asset corresponding to D 0 be the

numeraire .X0 WD 1/. If the market model satisfies the positive curvature assumption:
A2 > 0 (4.3)
then the portfolio allocation:
N Z
X t X
0 .t/ WD i .s/ dXi .s/ C J0A .t /˛ A .t / (4.4)
iD1 0 A
X J A .t /˛ A .t /
i
i .t/ WD ; i D 1; : : : ; N (4.5)
Xi .t /
A
is a self-financing arbitrage strategy delivering wealth:

Z t
V .t / D A2 .s/ ds (4.6)
0
Proof First, we check that the strategy is self-financing, that is:
N
X
.d X C dh ; X i/ D 0 (4.7)
D0

where “d” denotes the Ito differential (see Chapter 4.1.2 in Lamberton and Lapeyre
(2007)). This is proved by the following computation:
N
X
.d X C dh ; X i/
D0
N
X
D d0 X0 C dh0 ; X0 i C .di Xi C dhi ; Xi i/
iD1
N
XX X N
X X
˛ A
JiA dXi ˛ A JiA
D C d.˛ A J0A / C Xi d
Xi Xi
A iD1 A iD1 A
XN X A A
˛ Ji
C d ; Xi
Xi
iD1 A
X X N
D d ˛A JA
A D0
D0 (4.8)
Since the self-financing condition is fulfilled, the portfolio value can be computed as:
N
X
V .t / D .t /X .t /
D0
Z t X N
X
A
D i .s/ dXi .s/ C ˛ JA
0 A D0
„ ƒ‚ …
D0
Z tX N
X JiA .s/
D ˛ A .s/ dXi .s/
0 Xi .s/
A iD1
Z tX N
X
A
JA .s/
D ˛ .s/ dX .s/
0 D0
X .s/
A
Z tX
D ˛ A .s/2 ds
0 A
Z t
D A2 .s/ ds (4.9)
0
Since the arbitrage curvatures are positive, we see that V .0/ D 0 and V .t / > 0 for
all times t 2 Œ0; T . The proof is complete.

There is no continuous time trading in the markets, and we can only do measure-
ments in discrete time. Moreover, our estimate of ˝ will always include errors. This
means that we will always have a noise term on the right-hand side of Equation (4.1).
The goal of this section is to explain the basic steps used to measure arbitrage cur-
vature, and to understand the major sources of error in such measurements. A key
aspect of our algorithm is that we test directly for the gauge invariance of the arbi-
trage signal. This allows us to check the robustness of our estimators. We find that
the gauge invariance of the arbitrage signal, as predicted by the stochastic models, is
indeed obeyed with good accuracy in the real market.
4.1 Basic algorithm

In what follows, we will use a hat to signify that a variable is an estimate of some
parameter. For example, ˝O is an estimate for ˝. The first problem we face is finding
an estimate for the quadratic variation ˝ and determining the null space N defined
in Section 2 (if nontrivial). This is a familiar problem in volatility modeling. Since
we will never observe ˝ directly, it is expected that our estimate will not have any
exact zero mode, but only eigenvectors with small eigenvalues. In fact, a priori, we
do not know if the space N is nontrivial. We can only guess its dimension.
Let ˝O be any estimate for ˝. Then, following Proposition 2.2, we construct the
matrix:
1 O / C 1 Tr.U ˝/U
GO D ˝O .U ˝O C ˝U O (4.10)
N N2
where N is the number of rows (or columns) of ˝ and U is the matrix of all ones
U D 1; 8; . We can then use standard algorithms to compute the eigenspace of
O This will yield orthonormal eigenvectors:
G.
GO JO A D A JO A ; .JO A / JO B D ı AB ; A; B D 0; 1; : : : ; N 1 (4.11)
where A > 0 since GO is positive semidefinite. As a matter of fact, since ˝ and U

commute, they have a common basis of eigenvectors and a short computation proves
that G has always (at least) one zero eigenvalue and the biggest N 1 eigenvalues equal
those of ˝, which are not negative (see Proposition 2.2). In practice, there will only
be one exact zero eigenvector: JO 0 / .1; 1; : : : ; 1/ . Summarizing, the eigenvalues of
G, in increasing order of magnitude, are:
0 D 0 6 1 6 2 6 6 N 1 (4.12)
It is easy to show (see Proposition 2.2) that:

X
JOA D 0 for A D 1; 2; : : : ; N 1 (4.13)


Our estimate for the basis of N will be to chose the first k eigenvectors with the
smallest eigenvalues: JO A , A D 1; : : : ; k < N 1. In doing this, we are assuming
that dim.N / D k.
Once we have calculated JO A , we can compute our estimate of ˛ A in discrete time:
X JOA .t /
˛O A .t C ıt / D ŒX .t C ıt / X .t / (4.14)

ıtX .t /
Note that JO A .t/ is constructed with information up to time t only. This estimate is
consistent with the nonanticipating nature of Ito integrals. The time step ıt is, of
course, arbitrary. Our estimate for A2 now becomes:
k
X k
X
AO 2 .t C ıt / D A
Œ˛O .t / C 2
˛O A .t /Œ˛O A .t C ıt / ˛O A .t / (4.15)
AD1 AD1
In the limit of short timescales, and if there is nontrivial arbitrage, we expect that this
estimator will converge to the true signal:
X
AO 2 .t C ıt / D A2 .t/ C ˛ A d˛ A D A2 .t / C O.ıt /; ıt ! 0 (4.16)
A
The convergence in Equation (4.16) is only valid if, in the limit ıt ! 0, we have:
E t Œ˛O A .t Cıt / ˛O A .t/ D O.ıt /; cov t Œ˛O A .t Cıt /; ˛O B .t Cıt / D O.ıt / (4.17)
Therefore, we expect that, if there is nontrivial arbitrage in the market, the estimator
(4.15) will give us a positive signal on average. Since the timescale is arbitrary, it is
convenient to set ıt D 1 henceforth.
There are several candidates for an estimator for ˝. The “right” choice of ˝O should
reflect our beliefs about the true dynamics of the asset values. Here we will simply
take the empirical estimator for covariance of the time series of log returns for a
window of length L. More precisely, our data consists of a number of time series for
the prices X , D 0; : : : ; N 1, in certain units, say US dollars.5 Our estimator
reads:
L1
O 1 X X .t i / X .t i/
˝ .t/ D log log
L X .t i 1/ X .t i 1/
iD0
L1
1 X X .t i/ X .t j /
2 log log (4.18)
L X .t i 1/ X .t j 1/
i;j D0
For more sophisticated estimators, see Hardle et al (2008) and Zhang (2006). We are
now in a position to summarize the most basic algorithm to detect arbitrage.
5 We also include the US dollar itself as an asset in which we have X0 D 1.

4.1.1 Algorithm
(1) Starting with the time series for X , D 0; : : : ; N 1, in an interval Œt; t L,
we estimate ˝O .t/ using Equation (4.18).
(2) We then calculate the GO matrix using Equation (4.10), and its orthonormal
eigenspace. The eigenvectors will be labeled as JO A , A D 0; 1; : : : ; N 1,
in order of increasing eigenvalues 0 D 0 6 1 6 6 N 1 . Moreover,
JO 0 / .1; 1; : : : ; 1/ .
(3) Given a guess for the dimension of the null space k D dim.N /, we take as its
O JO A , A D 1; : : : ; k.
basis the following eigenvectors of G:
(4) We then calculate ˛O A .t C 1/ from Equation (4.14), which uses information up

to time t C 1.
(5) Roll the time window by one step, and repeat steps (1)–(4). Once we have
more than one estimate for ˛O A , we can calculate our final arbitrage estimator
AO 2 from Equation (4.15).
(6) In order to explicitly check for gauge invariance, we repeat steps (1)–(5), using
each asset X as a numeraire. For example, if we want to use X1 as a numeraire,
we divide all elements of the time series by the corresponding element of X1 , eg,
X .s/ ! X .s/=X1 .s/; 8 and s 2 Œt; t L. Then we repeat steps (1)–(5)
with the new time series. Note that this is a nontrivial transformation in the data
and, in practice, we will get different estimates for ˛O A .
Before discussing the results of Algorithm 4.1.1, we need to understand what the
main sources of error are in our signal. This is done in the next subsection.
4.2 Sources of error

The sources of error in our measurement of A2 can be divided into three groups. First,
there is gauge dependence. Second, there is a gauge-invariant noise, which we will
discuss below. Finally, when using high-frequency financial data, one is faced with
the so-called market microstructure noise, which is partly due to the bid–ask bounce
effect (see Hardle et al (2008)).
We begin by looking at sources of gauge dependence. Note that our construction
of the estimators assumes that, under a gauge transformation, ˝O transforms like
˝ (see Equation (2.13)). However, the gauge-transformation rule in the real world
can be quite different, because the unknown effective dynamics could lead to gauge
dependencies. We do not have an a priori test for this source of error. The only way

to test for it is to make our calculations in different gauges and see how different the
answers are. We show examples of this in the following sections.
The second source of error in our signals comes from a gauge-invariant noise term.
In fact, we will see that this is the dominant noise contribution. In order to understand
this noise, it is convenient to discretize the Ito integral and write our estimate for ˛ A
as:
X JOA .t /
˛O A .t C 1/ D ŒX .t C 1/ X .t /

X .t /
X X
D JOA .t /JB .t /˛ B .t / C JOA .t /a ˇ a .t /
;B ;a
X
C JOA .t /a ŒWa .t C 1/ Wa .t /
;a
A
WD ˛trend .t / C "A .t C 1/ (4.19)
Here we have decomposed the signal in a trend:

X X
A
˛trend .t/ WD JOA .t /JB .t /˛ B .t / C JOA .t /a ˇ a .t / (4.20)
;B ;a
and a stochastic noise term:

X
"A .t C 1/ WD JOA .t /a ŒWa .t C 1/ Wa .t / (4.21)
;a
with E t Œ"A .t C 1/ D 0. Since JO A is only an estimate for the real J A , we have that
P A a
O A
J ¤ 0 in general. Therefore, our error in the estimate of J will induce an
extra noise term in the signal. Moreover, it will also induce some gauge dependency.
To see this, note that, under a change of numeraire, we have a ! a C ı a and
ˇ a ! ˇ a C ı a . It is then easy to check that the trend will transform according to:
X
A A
˛trend ! ˛trend C JOA a ı a
;a
However, note that the noise term is gauge invariant. In fact, one expects the term
P A a
O
J to be quite small. Moreover, since, in Algorithm 4.1.1, the gauge transfor-
mation is of the order ı a D O.a /, we expect the gauge dependence coming from
the trend to be negligible. We will see that, in real financial data, most of the signal
can be accounted for by the gauge-invariant noise term.

We are interested in estimating the size of the noise contribution. For that, we
compute the variance of the noise using information up to time t :
X
var t ˛O A .t/˛O A .t C 1/
A
X 2
D Et ˛O A .t/.˛O A .t C 1/ E t Œ˛O A .t C 1//
A
X
D ˛O .t/˛O B .t/.ŒJO A .t / G.t /JO B .t //
A
A;B
X X
D Œ˛O A .t/2 A .t / C ˛O A .t /˛O B .t /.ŒJO A .t / ıG.t /JO B .t // (4.22)
A A;B
where ıG D G G. O If we think that our estimate of G is good, we can neglect the

O.ıG/ term and approximate:
X X
var t ŒAO 2 .t C 1/ Œ˛O A .t /2 A .t / 6 Œ˛O A .t /2 k .t / (4.23)
A A
where we remind the reader that k is our estimate for the dimension of N , and the
eigenvalues of GO have been ordered so that 1 6 2 6 6 k .
An interesting consequence of Equation (4.23) is that we can place a fundamental
bound on the size of the arbitrage curvature in order that it is detectable. We have:
p
A2 > var t ŒAO 2 H) A2 > k (4.24)
This means that, in order to have a chance to detect arbitrage, one needs to find
financial products whose time series are as correlated as possible, which implies a
very small value of k .
The third source of error is market microstructure noise. This effect is relevant in
high-frequency data, when the size of the price movements is comparable with the
bid–ask spread. In order to model this noise, it is convenient to set X0 WD 1 as our
numeraire. The standard way of simulating this noise is to introduce an additional
jump term
i .t/ to the log prices Xi , i D 1; : : : ; N . More precisely, the observed
price is XQ i and it is given by:
log XQ i .t / D log Xi .t / C
i .t / (4.25)
where Xi is the “true” Ito process, and, for simplicity, we assume that:
9
EŒXi
j D 0 >
=
EŒ
i D 0 (4.26)
>
;
EŒ
i
j WD
2 ıij

Moreover, the noise terms are uncorrelated between different times. We can then show
that our estimator will be contaminated by an amount:
4

2
EŒA D EŒA 2 C O
O 2 2
; ıt ! 0 (4.27)
ıt ıt 2
where: X 2
WD dim.N / E J0A
A
It can be shown that > 0. Therefore, we see that the microstructure noise leads a neg-
ative contribution to our estimation of A2 . The absolute value of such a contribution
diverges as we move toward higher frequencies (ıt ! 0).
One way of detecting the presence of microstructure noise is to note that:
Q
Xi .t C ıt / XQ i .t /
lim E log log D
2 < 0 (4.28)
ı t!0 XQ i .t / XQ i .t ıt /
In other words, the microstructure noise induces a negative correlation between sub-
sequent log returns. We find that this effect is quite pronounced for equity and futures
data. However, for stock indexes, the effect seems to be negligible. This is mainly due
to the fact that the microstructure noise “averages out” between all the stocks in the
index.
There is an extra source of error, which is intrinsic to Algorithm 4.1.1, but only if we
use a rolling window in our estimation of JO A . For example, suppose that we estimate
JO A .t/ and then roll the window and estimate JO A .t C 1/. Even if the matrices G.t
O / and
O C 1/ are near, JO A .t/ and JO A .t C 1/ can differ by a large orthogonal transform. It
G.t
can be just a sign flip, for example, since the eigenvalue equations are invariant under
JO A ! JO A . However, suppose two eigenvalues are near to each other, ie, 1 2 .
Then, any linear combination of JO 1 and JO 2 is also approximatively an eigenvector of
O In physics, this is known as the problem of degenerate perturbation theory (see,
G.
for example, Sakurai (1994)). More generally, we have that:
X
lim JO A .t C 1/ D C AB JO B .t / (4.29)
O
kG.t/ O C1/k!0
G.t B
where C is an orthogonal matrix, ie:
C C D 1 (4.30)
The problem can be solved if we can determine C . If so, we can construct the “correct”
eigenvectors: X
JQ A .t C 1/ WD .C /AB JO B .t C 1/
B

so that:
lim JQ A .t C 1/ D JO A .t /
O
kı Gk!0
An approximate solution for C , denoted by CO , can be found by minimizing the

Lagrangian:
L D TrŒ.CQ CO / .CQ CO / C TrŒ.CO CO 1/ (4.31)
where the k k real matrix CQ has components:
CQ AB WD ŒJQ A .t C 1/ JQ B .t / (4.32)
and is a symmetric matrix that serves as a Lagrange multiplier implementing the

constraint CO CO D 1. This is implemented in our numerical routines.
5 DYNAMIC ARBITRAGE STRATEGIES

In this section we apply Algorithm 4.1.1 to simulated financial data to construct
dynamic arbitrage strategies. First, we test our arbitrage detection algorithm, in order
to see whether arbitrage is indeed detectable or if it is masked by statistical noise.
Then, we backtest an equity indexes strategy, which is not actually tradable, unless
one can find appropriate exchange-traded funds. Here we discover arbitrage. Later,
we backtest a future indexes strategy, which is directly tradable. In this case arbitrage
is more difficult to find.
5.1 Arbitrage detection

To simulate the financial data we study the simple lognormal random walk model with
constant coefficients (see Equation (2.1)). The solution to the stochastic differential
equation (2.1) is:
d d
1X a 2 X
X .t/ D X .0/ exp ˛ . / t C a Ba .t / (5.1)
2
aD1 aD1
where B.t / WD ŒB1 .t /; : : : ; Bd .t / is a standard multivariate Brownian motion with:
EŒBa .t/ D 0; covŒBa .t /; Bb .t / D t ıab (5.2)
for all a; b D 1; : : : ; d . As usual, we decompose the trends as:

d
X X N 1
1 X a
˛ D ˛ C ˇ a O a C ˛ A
JA ; O a D a (5.3)
aD1
N D0
A2N

FIGURE 1 Simulation with twenty lognormal random walks.
0.06
0.04
Log prices
0.02
0.02
0.04
0 50 100 150 200
Time
We begin with an example with N D 21 assets and d D 18 Brownian motions,

which implies k D dim.N / D 2. We take as a first asset a bank account with a zero
interest rate, and make it our numeraire. This means that we choose:
X0 W 1; 0a D 0; ˛0 D 0 (5.4)
which implies:
N 1 d N 1 2
1 XX a a XX A A
˛D ˇ i ˛ Ji (5.5)
N aD1
iD1 iD1 AD1
In Figure 1 we show a particular simulation of the log prices, where we take ˇ a ,

ia , ˛ A from uniform random distributions in the intervals ˇ a 2 Œ104 ; 104 ,
ia 2 Œ103 ; 103 and ˛ A 2 Œ104 ; 104 . The simulation was generated using
Mathematica. The arbitrage detection algorithm was implemented in CCC. Each
price was taken at a time separation of t D 1 (arbitrary time unit). In this particular
case we calculate ˝O using the first 100 prices of the time series. In other words, we
do not use a moving window. The results with the moving window are very similar.
Now suppose we assume (correctly) that we have k D dim.N / D 2. We then run
Algorithm 4.1.1 and find the signal shown in Figure 2 on the facing page. The solid
horizontal line at A2 108 is the correct value of A2 . Therefore, we see that we
get an accurate estimate for the arbitrage curvature. Note that, as we discussed in the
previous section, in our algorithm we compute AO 2 using each of the different assets
as a numeraire. We include error bars showing the range of values obtained using the
different gauges. The results in this simulated sample are gauge invariant to such a
high accuracy that the error bars cannot be appreciated.

FIGURE 2 Result for the arbitrage detection algorithm applied to the simulated data in
Figure 1 on the facing page.
2×10−8
1.5×10−8
1×10−8
A2 5×10−9
−5×10−9
−1×10−8
100 120 140 160 180 200
Time
Here we assume (correctly) k D 2 null directions. The solid horizontal line at A2 108 is the correct value of A2 .
The gray solid line is the US dollar value of the signal.
In the previous section we discussed how the main source of error in our detection
technique can be related to the biggest eigenvalue k of the set f1 ; : : : ; k g. This
led to a gauge-invariant noise term. In this simulated sample data, we find that k
1021 , and so, using Equation (4.23), we find:
p p
varŒAO 2 108 1021 1015
Therefore, the noise term is very small in this case. The fluctuations seen in Figure 2 are
an artifact of this particular model. To understand them, we can expand Equation (5.1)
as:
X .t C 1/ X .t / X
D ˛ C a Ba .1/ C " C (5.6)
X .t/ a
where:
1 X
" D ˝ C a b Ba .1/Bb .1/ (5.7)
2
a;b
It is easy to show that " is gauge invariant and that:
EŒ" D 0; EŒ" " D 12 .˝ /2 (5.8)
This extra noise term, " , is the reason for the gauge-invariant fluctuations in Figure 2.
The noise term vanishes if we integrate dX using an infinite partition of the time
interval, as it is assumed in Ito integrals. Of course, this is never possible in practice.

Figure 1 on page 52.
2×10−8
1.5×10−8
1×10−8
A2 5×10−9
−5×10−9
−1×10−8
100 120 140 160 180 200
Time
Here we assume (incorrectly) k D 1 null directions and use a fixed window of 100 time steps. The error bars give
the range of values obtained using the different gauges. The solid dots are the mean of all results. The gray line near
to the time axis is the US dollar value of the signal.
Nevertheless, we see that, in this example, the extra noise is very small compared with
the arbitrage parameter A2 . In fact, we expect this noise to be very small in general
since it is of order varŒ" D O..a /4 /.
It is interesting to see what happens if we assume the wrong number of zero modes.
For example, in Figure 3 we show what happens if we take k D 1. We see that we
get a gauge dependent signal. Finally, in Figure 4 on the facing page we show what
happens if we assume k D 3. In this case, the biggest eigenvalue is k 108 .
As the figure shows, most of the fluctuations are coming from the gauge-invariant
noise described in the previous section. To see this we have plotted the expected noise
according to Equation (4.23):
p
noise˙ .t C 1/ D .A2 ˙ var t ŒAO 2 .t C 1//
v
u k
uX
D A ˙t
2
.˛O A .t //2 A .t / (5.9)
AD1
where A2 108 is the true value of the arbitrage (which is also the mean of the
signal). We see that this noise accounts for most of the fluctuations and it makes the
true arbitrage signal almost undetectable. The main point we would like to make here
is that the correct value of k can be estimated from the quality of the signal.

Figure 1 on page 52.
2×10−7
0
A2
−2×10−7
−4×10−7
100 120 140 160 180 200
Time
Assuming k D 3 null directions (incorrectly), and using a fixed window of 100 time steps. The gray lines are the
noise terms noise˙ estimated according to Equation (5.9). The error bars give the range of values obtained using
the different gauges. The solid dots are the mean of all results. The dashed line is the US dollar value of the signal.
Figure 1 on page 52, now including microstructure noise with variance
2 D 105 .
0.00002
−0.00002
A2
−0.00004
−0.00006
−0.00008
100 120 140 160 180 200
Time
Here we assume (correctly) k D 2 null directions.
We can now investigate the effect of the market microstructure noise discussed
in the previous section. In order to do this, we include additional white-noise terms
in the price processes of Equation (5.1) as described in the previous subsection (see

FIGURE 6 Product of subsequent log returns in the presence of microstructure noise,

according to Equation (5.10).
0.00003
Log return correlation

0.00002
0.00001
−0.00001
0 50 100 150 200
Time
The average of this signal is equal to 2 D 105 (dashed horizontal line), in agreement with the theoretical prediction.
Equation (4.25)). In this particular example we choose the variance

2 D 105 . We
then apply the noise to the data of the previous example. In Figure 4 on the preceding
page we show the result of the estimate of A2 for the contaminated data. In this case
we assume (correctly) that the dimension of the null space is k D 2. We can clearly
see how the signal is now negative on average, due to the microstructure noise. This
matches the theoretical prediction in Equation (4.27). In Figure 6 we plot the product
of subsequent log returns according to:
N 1 Q Q
1 X Xi .t C 1/ Xi .t /

O 2 .t/ WD log log (5.10)
N 1
i D1
XQ i .t / XQ i .t 1/
(see also Equation (4.28)), where XQ i is the contaminated price. According to Equa-
tion (4.28), we should have EŒ
O 2 D
2 . This is precisely what we observe in Figure 6.
In the next subsection, we will see that such signals are typical of high-frequency
security prices.
5.2 Equity index strategies

Here we present some examples of our arbitrage detection algorithm applied to real
financial data. We begin with a look at three major US stock indexes: the Dow Jones
composite average (DJA), the NASDAQ composite index (IXIC) and the NYSE com-
posite index (NYA). Due to their similar nature, we expect strong correlations between
these indexes. Our first sample consists of daily closing prices from September 1, 2004

FIGURE 7 Arbitrage detection algorithm applied to daily closing prices of three major US
indexes: DJA, IXIC and NYA.
0.00002
0.00001
A2 0
−0.00001
−0.00002
500 600 700 800 900 1000

Time
Here we show a sample of 500 data points. The gray lines are an estimate of the variance of the gauge-invariant
noise using Equation (5.11). The error bars give the range of values obtained using the different gauges. The solid
bars are the mean of all results. The black line is the US dollar value of the signal.
to July 16, 2009: a total of 1227 data points. The gauge-invariant matrix GO has been
estimated using a moving window of 500 days. We have found the following values
for the eigenvalues:
1 2 103 ; 2 5 103 ; 3 2 102
Therefore, it is reasonable to assume that the null space has only one dimension,
k D 1. The result of the arbitrage detection algorithm is shown in Figure 7. We
can see that the signal is indeed gauge invariant to a very high level of accuracy.
In Figure 7 we have also included an estimate for the gauge-invariant noise term
described in Section 4.2. In this case we have assumed that the average of the signal
is zero (ie, no-arbitrage), and so our estimate for the expected noise is:
p
noise˙ .t C 1/ D ˙ var t ŒAO 2 .t C 1/
v
u k
uX
D ˙t .˛O A .t //2 .t / A (5.11)
AD1
Looking at Figure 7, we see that the noise can explain most of the signal. Therefore,
we find that our results are consistent with A2 D 0, and hence no arbitrage. In Figure 8
on the next page we show a histogram of the different values of AO 2 . As pointed out

FIGURE 8 Histogram of different values of AO 2 obtained using daily market data for DJA,
IXIC and NYA.
300
250
200
150
100
50
0
−0.0001 −0.00005 0 0.00005 0.0001
A2
p
The signal-to-noise ratio is EŒAO 2 = varŒAO 2 0.0709.
above, the signal is consistent with A2 D 0 since the signal-to-noise ratio is very low:
EŒAO 2
p 0:0709
varŒAO 2
It is very instructive to look at the trading strategy exploiting the arbitrage discussed
in Proposition 4.1. In discrete time, the initial value of this portfolio is:
X
V .0/ D .0/X .0/ D 0

and the value at time t is simply:

t1 X
X X .s C 1/ X .s/
V .t / D ˛O A .s/JOA .s/
sD0 A;
X .s/
t1
X
D AO 2 .s C 1/ (5.12)
sD0
In Figure 9 on the facing page we show the value of this portfolio for the daily data
of the three US indexes. We include the integrated profit and loss of the indexes
themselves for comparison. We have multiplied the index signals by a numerical

FIGURE 9 Integrated profit and loss of the arbitrage portfolio (dashed black line) for the
daily data of the US stock indexes DJA, IXIC and NYA.
0.0005
∫ 0 A2 ds and indexes
0.0005
t
0.0010
500 600 700 800 900 1000 1100 1200
Time
We also show the integrated profit and loss of the indexes themselves.
FIGURE 10 Arbitrage detection algorithm applied to high-frequency data for three major
US indexes: DJA, IXIC and NYA.
3×10−8
2×10−8
1×10−8
A2 0
−1×10−8
−2×10−8
−3×10−8
1000 1020 1040 1060 1080 1100

Time
Here we show a sample of 100 data points. The gray lines are an estimate of the variance of the gauge-invariant
noise using Equation (5.11). The error bars give the range of values obtained using the different gauges. The solid
dots are the mean of all results. The black line is the US dollar value of the signal.
factor so that it fits in the same picture. Therefore, the overall scale on the vertical
axis is irrelevant. We can see that, as expected, the performance of this portfolio is
very poor for such low-frequency data.

FIGURE 11 Histogram of AO 2 obtained using high-frequency data for DJA, IXIC and NYA.
200
150
100
50
0
−1×10−8 0 1×10−8 2×10−8
A2
p
The signal-to-noise ratio is EŒAO 2 = varŒAO 2 0.32.
Next we look at the same index set (DJA, IXIC, NYA), but now at short timescales.
As an example, we study high-frequency data obtained on July 28, 2009. The data
points are separated by 7–10 seconds. The data was collected using the “Financial-
Data” package of Mathematica. The gauge-invariant matrix GO has been estimated
using a moving window of 500 data points. We have also assumed one null direc-
tion (k D 1). A sample of the arbitrage detection algorithm is shown in Figure 10
on the preceding page. It is quite obvious from this figure that the signal has a very
significant positive skewness. In fact, a prominent feature of the signal is a series
of positive peaks. These transient events have a duration of the order of five to ten
time steps, which, for this data, is about one minute. The amplitude of the peaks is
quite significant compared with the noise. We argue that these peaks are precisely
temporary fluctuations with A2 ¤ 0, that is, nonzero-curvature events in the market.
To show that these are not isolated events, Figure 11 shows the histogram for the full
data sample. We can see significant positive skewness in the signal, compared with
the daily data (see Figure 7 on page 57). In fact, we find a significant signal-to-noise
ratio:
EŒAO 2
p 0:32
varŒAO 2
The integrated profit and loss of the arbitrage portfolio of Equation (5.12) are shown
in Figure 12 on the facing page. We can see a very good performance in comparison
with the daily data (see Figure 9 on the preceding page). Because of model risk, such

FIGURE 12 Integrated profit and loss of the arbitrage portfolio (dashed black line) for the
high-frequency data of the US stock indexes DJA, IXIC and NYA.
8×10−7
∫ 0 A2 ds and indexes 6×10−7
4×10−7
2×10−7
−2×10−7
t
−4×10−7
500 600 700 800 900 1000 1100 1200
Time
We also show the integrated profit and loss of the indexes themselves.
a portfolio can indeed have a finite probability of a loss on short timescales. However,
we see that, on longer timescales (integrated signal), the probability of a loss goes
to zero asymptotically as t ! 1. This is an example of a statistical arbitrage as
discussed in Pole (2007) and Bondarenko (2003).
We have also studied the effect of the microstructure noise on the high-frequency
signal. In particular, we have computed the estimate of the noise
O 2 defined in Equa-
tion (5.10). We have found that, for this particular data sample, the contribution from
such noise is very low:
EŒ
O 2
p 0:04
varŒ
O 2
However, if we look at traded assets such as stocks and futures, the effect becomes
quite significant.
5.3 Index futures strategies

Our next data sample consists of the following set of US index futures: E-Mini
S&P 500 (ESU09.CME), DJIA mini-sized (YMU09.CBT), E-Mini Nasdaq 100
(NQU09.CME) and S&P 500 index future (SPU09.CME). The data was collected
on August 9, 2009, and all futures expire on September 18, 2009. We have collected
prices with a frequency of seven to ten seconds separation, using the “Financial-
Data” package of Mathematica. These securities are highly correlated. Therefore,
they are ideal for the search for the arbitrage signal. However, since these are traded

FIGURE 13 Histogram of AO 2 obtained using high-frequency data for the index futures:
ESU09.CME, YMU09.CBT, NQU09.CME, SPU09.CME.
1000
800
600
400
200
0
−1×10−7 −5×10−8 0 5×10−8 1×10−7 1.5×10−7
2
A
p
The signal-to-noise ratio is EŒAO 2 = varŒAO 2 0.061. This figure illustrates the negative effects of the market
microstructure noise for the simplest trading strategy.
instruments, the effect of the bid–ask spread is more pronounced. In Figure 13 we

show the histogram of the values of AO 2 obtained by applying exactly the same algo-
rithm as in the previous example. We get a very poor signal, which is contaminated
by the microstructure noise; in fact, we get a negative mean:
EŒAO 2
p 0:061
varŒAO 2
The integrated profit and loss of the simple portfolio of Equation (5.12) are shown in
Figure 14 on the facing page.
We have also calculated the effect of the microstructure noise, by computing the
estimate
O 2 defined in Equation (5.10). The effect for this data sample is about an
order of magnitude bigger than the previous example:
EŒ
O 2
p 0:15
varŒ
O 2
This noise is the main obstacle to a detection of A2 . Nevertheless, one can devise
more complicated detection methods that filter out the microstructure noise, whose
effect is minimized by trading at lower frequency but using higher-frequency data
to calculate the null space. As a matter of fact, when looking at the expression in
Equation (4.27) describing the contamination of the arbitrage estimator by the market

FIGURE 14 Integrated profit and loss of the arbitrage portfolio (dashed black line) of Equa-
tion (5.12) for the high-frequency data of the US index futures: ESU09.CME, YMU09.CBT,
NQU09.CME, SPU09.CME.
∫ 0 A2 ds and futures 5×10−7
−5×10−7
−1×10−6
t
−1.5×10−6
500 1000 1500 2000 2500
Time
We also show the integrated profit and loss of the futures themselves. This figure illustrates the negative effects of
the market microstructure noise for the simplest trading strategy.
microstructure noise, we note that, for small values of the trading period ıt , the
longer the period, the smaller the contamination. So, if we keep high-frequency data
to compute the (approximate instantaneous) covariance matrix ˝, O while increasing
the trading period in such a way that the approximation relation (4.27) still holds, we
can filter out the market microstructure noise and obtain a clear arbitrage signal. In
Figure 15 on the next page we show the integrated profit and loss of this particular
strategy.
A detailed study of similar strategies requires a precise calibration of the trading
period: it must be sufficiently long that it clearly reduces the contamination but,
at the same time, sufficiently short that the arbitrage contamination relation is still
valid. Every asset universe requires its own calibration, which needs, as all statistical
parameters utilized here do, a regular update.
6 CONCLUSIONS
In this paper we have defined a general measure of arbitrage that is invariant under
changes of numeraire and equivalent probability measure. Our main assumption is
that all financial instruments can be described by Ito processes. This is not a very
strong assumption, as many complex financial models, including those reflecting the
non-Gaussian nature of stock returns, can be modeled this way. We showed that
the gauge-invariant arbitrage measure can be interpreted in terms of the curvature

FIGURE 15 Integrated profit and loss of an arbitrage portfolio (dashed black line) for
low-frequency trading and high-frequency data (for null space computational purposes) of
the US index futures: ESU09.CME, YMU09.CBT, NQU09.CME, SPU09.CME.
3×10−6
∫ 0 A2 ds and futures
2×10−6
1×10−6
0
t
1×10−6
500 1000 1500 2000 2500
Time
We also show the integrated profit and loss of the futures themselves.This particular strategy is designed to minimize
the effects of the microstructure noise.
of the stochastic version of the Malaney–Weinstein connection (Malaney (1996) and

Weinstein (2006)). The zero-curvature condition is then equivalent to the no-arbitrage
principle up to the Novikov condition for the asset value dynamics. Moreover, we
demonstrated a simple generalization of the classic asset pricing theorem to include
arbitrage. Finally, we presented a basic algorithm to measure the market curvature
using financial data. We found evidence for nonzero-curvature fluctuations in high-
frequency data involving stock indexes and index futures.
From a financial perspective, we used our algorithms to exploit arbitrage system-
atically, and to generate profitable dynamic trading strategies. However, a distinction
must be made between the case where assets are directly tradable (eg, index futures)
and the case where this cannot be achieved (eg, index equities). In the tradable asset
case, arbitrage is less easily detected than in the nontradable asset case and it is likely
to be destroyed by the market microstructure noise. Moreover, we have completely
neglected transaction costs. Even when the real asset universe (eg, exchange-traded
funds) has low transaction costs, these could destroy the profitability of the dynamic
arbitrage strategies depicted. The right way to tackle this problem is to develop a theory
handling arbitrage and transaction costs at the same time. This will require much more
empirical research, and the development of more sophisticated techniques to estimate
the arbitrage curvature measure A2 . This is left for future work. For the time being,
we can still find a profitable strategy with tradable assets by optimizing the trading

period to reduce the market microstructure noise and by regularly recalibrating the
parameters.
From a scientific perspective, we believe that our findings represent a modest step
toward an understanding of nonequilibrium market dynamics. Gauge theories provide
the natural mathematical language to that aim, and arbitrage opportunities can be
interpreted as a nonzero-curvature fluctuation in an economy out of equilibrium. It is
interesting that most of our current economic and financial thinking relies so heavily
on the assumptions of general equilibrium theory.
There has been a growing consensus that we need a better understanding of the
nonequilibrium dynamics of the economy (see, for example, Farmer and Geanakoplos
(2008)). In particular, we would like to understand what the relaxation timescale is for
nonequilibrium fluctuations to disappear (if they do). Within the limited data sample
that we have shown in this paper, the relaxation time seems to be of the order of one
minute. However, this can be very different in other sectors of the market.
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The Journal of Investment Strategies (23–66) Volume 1/Number 2, Spring 2012

Gauge invariance, geometry and arbitrage

can also be shown to be equivalent to a weaker form of economic equilibrium (see

1 For example, .t/ can be the euro–US dollar exchange rate.

The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

et al (2001). For an unrelated use of differential geometric methods in (no-arbitrage)

where F D @ A @ A is known as the curvature of A. Therefore, we see

Research Paper www.thejournalofinvestmentstrategies.com

2 STOCHASTIC MODELS AND GAUGE INVARIANCE

The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

EŒWa .t/ Wa .0/ D 0; covŒWa .t / Wa .0/; Wb .t / Wb .0/ D t ıab (2.2)

Research Paper www.thejournalofinvestmentstrategies.com

X .t / ! .t /X .t / (2.6)

where is a positive stochastic process that is adapted to the filtration F . Another

The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

Finally, under a transformation of the probability measure given by the Radon–

we have the mapping of standard Brownian motions:

dX0 D dX C dX C dh; X i

Research Paper www.thejournalofinvestmentstrategies.com

Then, it follows from Equation (2.4) that:

which can only be true if a D 0; 8a.

The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

It is then straightforward to verify the gauge invariance of the matrix G. Next we

Research Paper www.thejournalofinvestmentstrategies.com

martingale representation theorem can only be obtained if one is able to write:

By Proposition 2.2, there is neither a change of probability nor a choice of a positive

The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

It is easy to verify that J obeys the properties given in Equation (2.4).

dX0 D rX0 dt (2.21)

Research Paper www.thejournalofinvestmentstrategies.com

For ˛Q D 0, Equations (2.21)–(2.23) reduce to the familiar no-arbitrage Black–Scholes

The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

This is a simple example of the well-known volatility arbitrage.

3 THE GAUGE CONNECTION

Research Paper www.thejournalofinvestmentstrategies.com

X ! .X/X , the connection transforms as:

where is a particular self-financing trajectory .s; .s/; X.s//, s 2 Œt; T , and D is

where ı represents a variation to the trajectory of the portfolio nominals. Therefore,

R;t D 0 H) XP .t / D ˛.t /X .t /; 8

The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

for T > t . In particular, if V .t/ D 0, it follows that V .T / D 0. Therefore, it is

V .T / D .D1 D2 /V1 .t / > 0 (3.10)

3.1 The stochastic gauge connection

Research Paper www.thejournalofinvestmentstrategies.com

where is some self-financing trajectory, and is given by the expectation of the

Proof We start by writing the portfolio return as:

The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

A simple application of Ito’s rule gives:

A further application of Ito’s rule gives:

This Radon–Nykodým derivative is a martingale if the Novikov condition:

is satisfied. Therefore, using Equations (3.21) and (3.22) in (3.20), we obtain:

Research Paper www.thejournalofinvestmentstrategies.com

In order to prove that can be written as an expectation of the Malaney–Weinstein

In particular, under the no-arbitrage assumption ˛ A D 0, we recover the classic

X D ŒX0 ; X1 ; : : : ; Xn ; ˚1 .X ; t/; : : : ; ˚m .X ; t / (3.28)

We will label the components of this vector by X , D 0; 1; : : : ; n C m. Moreover,

The Journal of Investment Strategies Volume 1/Number 2, Spring 2012

ŒX1 ; : : : ; Xn , and dX0 D X0 r dt describes a savings account with deterministic

which can only be true if a D 0; 8a.

where is a particular self-financing trajectory .s; .s/; X.s//, s 2 Œt; T , and D is

Moreover, since X0 is a deterministic process, it follows that 0a D 0. In order

where A > 0 since GO is positive semidefinite. As a matter of fact, since ˝ and U

and is a symmetric matrix that serves as a Lagrange multiplier implementing the

1 2 103 ; 2 5 103 ; 3 2 102