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Losing Money on Arbitrages: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities

  • Liu, Jun
  • Longstaff, Francis A
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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 economics of arbitrage. We derive the optimal investment policy for a risk-averse investor in a market where there are arbitrage opportunities. We show 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 arbitrage strategy may underperform the riskless asset or have an unimpressive Sharpe ratio. Furthermore, the arbitrage portfolio typically experiences losses at some point before the final convergence date. These results have important implications for the role of arbitrageurs in financial markets.

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Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number qt48k8f97f.

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Date of creation: 01 Jun 2000
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Handle: RePEc:cdl:anderf:qt48k8f97f
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Web page: http://www.escholarship.org/repec/anderson_fin/

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  1. Mark Grinblatt & Francis A. Longstaff, 2000. "Financial Innovation and the Role of Derivative Securities: An Empirical Analysis of the Treasury STRIPS Program," Journal of Finance, American Finance Association, vol. 55(3), pages 1415-1436, 06.
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  12. Jean-Pierre Zigrand, 1999. "Arbitrage and Endogenous Market Integration," FMG Discussion Papers dp319, Financial Markets Group.
  13. Chen Zhiwu, 1995. "Financial Innovation and Arbitrage Pricing in Frictional Economies," Journal of Economic Theory, Elsevier, vol. 65(1), pages 117-135, February.
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  16. Tuckman, Bruce & Vila, Jean-Luc, 1992. " Arbitrage with Holding Costs: A Utility-Based Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1283-302, September.
  17. Dumas, Bernard, 1992. "Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World," Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 153-80.
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