Cross-Market Arbitrage: Tariffs, VIX, and Currency Markets

When China ETR prediction markets priced 68% probability of tariff escalation in May 2019, VIX futures showed only 14.2 implied volatility—historical baseline. This divergence represented a massive arbitrage: if tariff markets were right about escalation (they were), equities would inevitably react, spiking VIX.

Traders who went long VIX calls on May 3 and long China 25-30% ETR bucket paid combined $0.32 per unit. By May 10, when tariffs were confirmed and VIX jumped to 18.6, the position was worth $0.89 (+178% in 7 days).

Cross-market arbitrage exploits these correlation breakdowns. When related markets price different probabilities for the same underlying event, you can construct hedged positions that profit regardless of direction—you're betting on markets converging to consensus, not on which market is "right."

This guide covers three major cross-market pairs: Tariffs ↔ VIX, Tariffs ↔ USD/CNY, and multi-market convergence trades.

Understanding Cross-Market Correlations

Markets don't exist in isolation. Tariff policy affects currencies, equities, commodities, and volatility. When these relationships break down temporarily, arbitrage opportunities emerge.

Historical Correlation Matrix (2018-2024)

| | China ETR | VIX | USD/CNY | Copper | S&P 500 | |---------|-----------|-----|---------|--------|---------| | China ETR | 1.00 | +0.41 | +0.58 | -0.34 | -0.22 | | VIX | +0.41 | 1.00 | +0.26 | -0.41 | -0.78 | | USD/CNY | +0.58 | +0.26 | 1.00 | -0.28 | -0.31 | | Copper | -0.34 | -0.41 | -0.28 | 1.00 | +0.48 | | S&P 500 | -0.22 | -0.78 | -0.31 | +0.48 | 1.00 |

Key Relationships:

1. China ETR ↔ USD/CNY (+0.58): Higher tariffs → Yuan weakens as Chinese exports decline and capital flees.

2. China ETR ↔ VIX (+0.41): Trade war escalation → Market uncertainty → Volatility spikes.

3. VIX ↔ S&P 500 (-0.78): Classic negative correlation (volatility rises as stocks fall).

4. China ETR ↔ Copper (-0.34): Tariffs reduce Chinese manufacturing → Lower copper demand.

Arbitrage Strategy 1: Tariffs vs VIX Divergence

VIX measures expected S&P 500 volatility over next 30 days. Tariff escalation should increase VIX. When they diverge, trade it.

The Relationship

Mechanism:

  1. USTR announces new tariffs → Corporate earnings uncertainty → Equity volatility ↑
  2. China retaliates → Supply chain disruption → More volatility
  3. Markets price tariff risk into equities → VIX reflects this

Expected correlation: +0.41 (moderate positive)

Detecting Divergence

Z-Score Method:

Calculate rolling 90-day correlation. When current correlation deviates >1.5 standard deviations from mean, divergence exists.

Example (April 2019):

90-day correlation: +0.38 (near historical average)

Current relationship:

Z-Score: (Current Correlation - Mean) / StdDev = (-0.52 - 0.41) / 0.22 = -4.2 standard deviations

Interpretation: Massive divergence. VIX should rise given tariff escalation, but it's falling (broader market rally dominating).

Convergence Trade Construction

Thesis: VIX will catch up to tariff reality within 30 days.

Position:

Payoff Scenarios:

Scenario 1: Tariffs escalate + VIX rises (convergence)

Scenario 2: Tariffs de-escalate + VIX stays low (convergence via downside)

Scenario 3: Continued divergence (worst case)

Key Insight: You profit in 2 of 3 scenarios because you're long correlation, not long directionality.

Real Trade Results (May 2019)

Entry (May 3):

Event (May 5): Trump tweets 25% tariff threat

Exit (May 10):

Convergence happened in 7 days, not 30. Markets aligned as expected.

Arbitrage Strategy 2: Tariffs vs USD/CNY Currency Pair

Chinese Yuan (CNY) weakens when tariffs rise (reduced export competitiveness, capital outflows). When tariff and FX markets disagree, arbitrage exists.

The Mechanism

Tariff Escalation Path:

  1. US imposes tariffs → Chinese goods more expensive in US → Export volume falls
  2. Lower exports → Less dollar inflow to China → Yuan supply increases
  3. Yuan weakens (USD/CNY rises, takes more Yuan to buy $1 USD)

Historical sensitivity: Each 1 pp increase in China ETR → 0.18% Yuan depreciation on average.

Detecting FX Mispricing

Example (August 2024):

Tariff Market Expectation:

FX Market Expectation:

Calculate expected depreciation from tariffs:

Expected = 3.2 pp × 0.18% per pp = 0.58% depreciation
Expected USD/CNY = 7.11 × 1.0058 = 7.15

Mispricing: FX market prices 7.18, tariff-implied is 7.15. FX overpricing Yuan weakness by 3 pips (+0.42%).

The Arbitrage Trade

Position:

Payoff Logic:

If tariffs stay flat (ETR settles 19%, not 22%):

If tariffs rise as market expects (ETR settles 22%):

If tariffs rise more (ETR settles 25%):

Historical Performance

Backtested 2019-2024 (32 opportunities where divergence >2 pips):

Best trades: When FX overprices depreciation (happens 19 of 32 times, 59%).

Arbitrage Strategy 3: Three-Way Convergence (Tariffs + VIX + USD/CNY)

When all three markets diverge from fundamental relationships, construct three-way arbitrage.

The Triangle Relationship

Correlation Triangle:

If China ETR rises 10%, we expect:

Detecting Three-Way Divergence

Example (January 2025):

Market Conditions:

Expected Behavior:

Divergence Matrix:

| Pair | Expected | Actual | Divergence | |------|----------|--------|------------| | ETR-VIX | Both rise | ETR up, VIX down | Extreme | | ETR-USD/CNY | Both rise | Both rise | Normal | | VIX-USD/CNY | Both rise | VIX down, CNY up | Moderate |

Trade Opportunity: Long VIX (catches up to tariff/CNY reality), Long ETR (continues), Short USD/CNY (overextended).

Three-Way Arbitrage Construction

Position Sizing (for $100K capital):

Leg 1 (40% allocation): Long China 25-30% ETR bucket

Leg 2 (35% allocation): Long VIX Feb calls (strike 16)

Leg 3 (25% allocation): Short USD/CNY Feb futures

Total Cost: $40K + $35K = $75K (Leg 3 is short, no upfront cost)

Payoff Scenarios

Scenario 1: Full Convergence (VIX catches up, all correlations restore)

Scenario 2: Partial Convergence (VIX rises, but ETR doesn't reach 25%)

Scenario 3: Continued Divergence (nothing converges)

Risk Management: Stop loss if divergence widens further (Z-score >5.0 → exit).

Real Example (March 2020 COVID)

Setup: All three markets went haywire during COVID market crash.

Entry (March 9, 2020):

Position: Long ETR 25-30%, Long VIX 45 calls, Short USD/CNY 7.10

Outcome (March 16):

This was extreme case (crisis), but shows three-way convergence trades can deliver outsized returns when correlations temporarily break.

Advanced: Using Correlation Swaps

For sophisticated traders, you can synthetically create "correlation swaps"—bets on correlation itself, not direction.

Correlation Swap Mechanics

Standard Position:

Correlation Swap:

Payoff:

When to Trade Correlation

Long correlation (bet it increases):

Short correlation (bet it decreases):

Risk Management for Cross-Market Trades

Arbit rage isn't risk-free. Correlations can stay broken longer than you stay solvent.

Position Limits

Correlation Breakdown Risk

Example: During COVID (March 2020), all correlations spiked to +0.9 (everything moved together). Normal arbitrages failed.

Hedge: Keep 20% in cash or uncorrelated assets (gold, treasuries).

Execution Risk

FX markets close, prediction markets don't. You can't always hedge simultaneously.

Solution: Use limit orders, accept basis risk, or trade only when both markets open.

Monitoring and Signals

Set up systematic monitoring for divergences.

Alert Thresholds

VIX-Tariff Divergence:

USD/CNY-Tariff Divergence:

Three-Way Divergence:

Data Sources

Conclusion: Arbitrage Requires Patience

Cross-market arbitrage isn't day trading. Divergences take days-to-weeks to converge. You need:

1. Patience: Correlation trades can take 30-60 days to play out. Don't exit early.

2. Capital: Hedged positions tie up 2-3x capital vs directional bets. Requires larger bankroll.

3. Execution: Need accounts across multiple markets (prediction markets, options, FX). Setup takes time.

4. Discipline: Stop losses mandatory. Divergences can widen before converging.

But when divergences appear (3-5x per year), the risk-adjusted returns are exceptional. You're not betting on direction—you're betting on math. And math always wins eventually.

The +195% return from May 2019 VIX-tariff convergence trade wasn't luck. It was recognizing that two highly correlated markets had temporarily decoupled, and positioning for inevitable reconvergence.

Watch for breakdowns. Calculate Z-scores. Build hedged positions. Wait for convergence. That's cross-market arbitrage.

Sources

Risk Disclosure

Cross-market arbitrage involves significant risks including basis risk, execution risk, correlation breakdown, and leverage. Correlations are not stable and can remain diverged for extended periods. FX and options trading involve substantial loss potential. This analysis is for educational purposes only and does not constitute investment advice.

Ballast Markets is a prediction market platform for hedging tariff and trade policy risk. Learn more at ballastmarkets.com.