Jun Liu (Anderson School of Management) Francis Longstaff (Anderson School of Management)
Abstract
In theory, an investor can make infinite profits by taking unlimited positions in an arbitrage. In reality, however, investors must satisfy margin requirements which completely change the nature of the returns from arbitrage. We derive the optimal investment policy for a risk-averse investor in a market where there are arbitrage opportunities. We shoe that it is often optimal to underinvest in the arbitrage by taking a smaller position than margin constraints allow. In some cases, it is actually optimal for an investor to walk away from a pure arbitrage opportunity. Even when the optimal policy is followed, the returns from the arbitrage strategy can be unimpressive in the sense of underperforming the reckless asset or having a mediocre Sharpe ratio. Furthermore, the arbitrage portfolio frequently experiences capital losses at some point before the final convergence date of the arbitrage. These results have many important implications for the role of arbitrageurs in financial markets.
Download Info
To download:
If you experience problems downloading a file, check if you have the
proper application to
view it first. Information about this may be contained
in the File-Format links below. In case of further problems read
the IDEAS help
page. Note that these files are not on the IDEAS
site. Please be patient as the files may be large.
For technical questions regarding this item, or to correct its listing, contact: (Christopher F. Baum).
Related research
Keywords:
Other versions of this item:
Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)