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

Jun Liu and Francis A Longstaff

University of California at Los Angeles, Anderson Graduate School of Management from Anderson Graduate School of Management, UCLA

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 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.

Date: 2000-06-01
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Citations: View citations in EconPapers (14)

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Journal Article: Losing Money on Arbitrage: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities (2004)
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