IDEAS home Printed from https://ideas.repec.org/p/cpr/ceprdp/7188.html
   My bibliography  Save this paper

Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications

Author

Listed:
  • Timmermann, Allan
  • Liu, Jun

Abstract

We define risky arbitrages as self-financing trading strategies that have a strictly positive market price but a zero expected cumulative payoff. A continuous time cointegrated system is used to model risky arbitrages as arising from a mean-reverting mispricing component. We derive the optimal trading strategy in closed-form and show that the standard textbook arbitrage strategy is not optimal. In a calibration exercise, we show that the optimal strategy makes a sizeable difference in economic terms.

Suggested Citation

  • Timmermann, Allan & Liu, Jun, 2009. "Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications," CEPR Discussion Papers 7188, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:7188
    as

    Download full text from publisher

    File URL: https://cepr.org/publications/DP7188
    Download Restriction: CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Bernard Dumas & Alexander Kurshev & Raman Uppal, 2009. "Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility," Journal of Finance, American Finance Association, vol. 64(2), pages 579-629, April.
    2. Jun Liu, 2004. "Losing Money on Arbitrage: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities," The Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 611-641.
    3. Evan Gatev & William N. Goetzmann & K. Geert Rouwenhorst, 2006. "Pairs Trading: Performance of a Relative-Value Arbitrage Rule," The Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 797-827.
    4. Péter Kondor, 2009. "Risk in Dynamic Arbitrage: The Price Effects of Convergence Trading," Journal of Finance, American Finance Association, vol. 64(2), pages 631-655, April.
    5. Joel Hasbrouck, 2003. "Intraday Price Formation in U.S. Equity Index Markets," Journal of Finance, American Finance Association, vol. 58(6), pages 2375-2400, December.
    6. Summers, Lawrence H, 1986. "Does the Stock Market Rationally Reflect Fundamental Values?," Journal of Finance, American Finance Association, vol. 41(3), pages 591-601, July.
    7. Hogan, Steve & Jarrow, Robert & Teo, Melvyn & Warachka, Mitch, 2004. "Testing market efficiency using statistical arbitrage with applications to momentum and value strategies," Journal of Financial Economics, Elsevier, vol. 73(3), pages 525-565, September.
    8. Oleg Bondarenko, 2003. "Statistical Arbitrage and Securities Prices," The Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 875-919, July.
    9. Jun Liu, 2007. "Portfolio Selection in Stochastic Environments," The Review of Financial Studies, Society for Financial Studies, vol. 20(1), pages 1-39, January.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Emmanouil Mavrakis & Christos Alexakis, 2018. "Statistical Arbitrage Strategies under Different Market Conditions: The Case of the Greek Banking Sector," Journal of Emerging Market Finance, Institute for Financial Management and Research, vol. 17(2), pages 159-185, August.
    2. David S. Sun & Shih-Chuan Tsai & Wei Wang, 2013. "Behavioral Investment Strategy Matters: A Statistical Arbitrage Approach," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 49(S3), pages 47-61, July.
    3. Ahmet Göncü & Erdinc Akyildirim, 2017. "Statistical Arbitrage In The Multi-Asset Black–Scholes Economy," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 12(01), pages 1-18, March.
    4. Ahmet G�nc�, 2015. "Statistical arbitrage in the Black-Scholes framework," Quantitative Finance, Taylor & Francis Journals, vol. 15(9), pages 1489-1499, September.
    5. Guglielmo Maria Caporale & Luis Gil-Alana & Alex Plastun, 2017. "Searching for Inefficiencies in Exchange Rate Dynamics," Computational Economics, Springer;Society for Computational Economics, vol. 49(3), pages 405-432, March.
    6. Chen, Shiyi & Chng, Michael T. & Liu, Qingfu, 2021. "The implied arbitrage mechanism in financial markets," Journal of Econometrics, Elsevier, vol. 222(1), pages 468-483.
    7. Erdinc Akyildirim & Ahmet Goncu & Alper Hekimoglu & Duc Khuong Nguyen & Ahmet Sensoy, 2023. "Statistical arbitrage: factor investing approach," OR Spectrum: Quantitative Approaches in Management, Springer;Gesellschaft für Operations Research e.V., vol. 45(4), pages 1295-1331, December.
    8. Christian Rein & Ludger Rüschendorf & Thorsten Schmidt, 2021. "Generalized statistical arbitrage concepts and related gain strategies," Mathematical Finance, Wiley Blackwell, vol. 31(2), pages 563-594, April.
    9. Alexakis, Christos, 2010. "Long-run relations among equity indices under different market conditions: Implications on the implementation of statistical arbitrage strategies," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 20(4), pages 389-403, October.
    10. Focardi, Sergio M. & Fabozzi, Frank J. & Mitov, Ivan K., 2016. "A new approach to statistical arbitrage: Strategies based on dynamic factor models of prices and their performance," Journal of Banking & Finance, Elsevier, vol. 65(C), pages 134-155.
    11. Adrian, Tobias, 2009. "Inference, arbitrage, and asset price volatility," Journal of Financial Intermediation, Elsevier, vol. 18(1), pages 49-64, January.
    12. Psaradellis, Ioannis & Laws, Jason & Pantelous, Athanasios A. & Sermpinis, Georgios, 2023. "Technical analysis, spread trading, and data snooping control," International Journal of Forecasting, Elsevier, vol. 39(1), pages 178-191.
    13. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity -- Theory and Empirical Evidence," NBER Working Papers 18251, National Bureau of Economic Research, Inc.
    14. Eduardo Dávila & Daniel D. Graves & Cecilia Parlatore, 2022. "The Value of Arbitrage," NBER Working Papers 29744, National Bureau of Economic Research, Inc.
    15. Atanasova, Christina & Weisskopf, Jean-Philippe, 2020. "The price of international equity ETFs: The role of relative liquidity," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 65(C).
    16. Chen, Xingjiang & Ruan, Xinfeng & Zhang, Wenjun, 2021. "Dynamic portfolio choice and information trading with recursive utility," Economic Modelling, Elsevier, vol. 98(C), pages 154-167.
    17. Calvet, Laurent-Emmanuel & Grandmont, Jean-Michel & Lemaire, Isabelle, 2018. "Aggregation of heterogenous beliefs, asset pricing, and risk sharing in complete financial markets," Research in Economics, Elsevier, vol. 72(1), pages 117-146.
    18. Ahmet Göncü & Erdinc Akyildirim, 2016. "A stochastic model for commodity pairs trading," Quantitative Finance, Taylor & Francis Journals, vol. 16(12), pages 1843-1857, December.
    19. Kasper Johansson & Thomas Schmelzer & Stephen Boyd, 2024. "Finding Moving-Band Statistical Arbitrages via Convex-Concave Optimization," Papers 2402.08108, arXiv.org.
    20. Xiong, Wei, 2001. "Convergence trading with wealth effects: an amplification mechanism in financial markets," Journal of Financial Economics, Elsevier, vol. 62(2), pages 247-292, November.

    More about this item

    Keywords

    Cointegrated asset prices; Optimal portfolio choice; Risky arbitrage;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:cpr:ceprdp:7188. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: the person in charge (email available below). General contact details of provider: https://www.cepr.org .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.