Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications

44 Pages Posted: 11 Mar 2009

See all articles by Jun Liu

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Date Written: March 2009

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.

Keywords: cointegrated asset prices, optimal portfolio choice, risky arbitrage

JEL Classification: G11

Suggested Citation

Liu, Jun and Timmermann, Allan, Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications (March 2009). CEPR Discussion Paper No. DP7188, Available at SSRN: https://ssrn.com/abstract=1356397

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

Allan Timmermann (Contact Author)

UCSD ( email )

9500 Gilman Drive
La Jolla, CA 92093-0553
United States
858-534-0894 (Phone)

HOME PAGE: http://rady.ucsd.edu/people/faculty/timmermann/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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