Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications
44 Pages Posted: 11 Mar 2009
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: Suggested Citation
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