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Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications

  • Liu, Jun
  • Timmermann, Allan G

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7188.

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Date of creation: Mar 2009
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Handle: RePEc:cpr:ceprdp:7188
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  1. 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.
  2. Evan Gatev & William N. Goetzmann & K. Geert Rouwenhorst, 2006. "Pairs Trading: Performance of a Relative-Value Arbitrage Rule," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 797-827.
  3. 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.
  4. Oleg Bondarenko, 2003. "Statistical Arbitrage and Securities Prices," Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 875-919, July.
  5. 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, 04.
  6. Jun Liu, 2007. "Portfolio Selection in Stochastic Environments," Review of Financial Studies, Society for Financial Studies, vol. 20(1), pages 1-39, January.
  7. Liu, Jun & Longstaff, Francis A, 2000. "Losing Money on Arbitrages: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities," University of California at Los Angeles, Anderson Graduate School of Management qt48k8f97f, Anderson Graduate School of Management, UCLA.
  8. 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.
  9. P├ęter Kondor, 2009. "Risk in Dynamic Arbitrage: The Price Effects of Convergence Trading," Journal of Finance, American Finance Association, vol. 64(2), pages 631-655, 04.
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