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

61 Pages Posted: 11 Dec 2000

See all articles by Jun Liu

Jun Liu

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

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area

Date Written: June 2000

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 is 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 to 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.

Keywords: Arbitrage, margin requirements, optimal portfolio

JEL Classification: D9, G0, G1

Suggested Citation

Liu, Jun and Longstaff, Francis A., Losing Money on Arbitrage: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities (June 2000). Available at SSRN: https://ssrn.com/abstract=246835 or http://dx.doi.org/10.2139/ssrn.246835

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)

Francis A. Longstaff (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2218 (Phone)
310-206-5455 (Fax)

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