Dynamic Portfolio Selection in Arbitrage

53 Pages Posted: 26 Feb 2006

See all articles by Jakub W. Jurek

Jakub W. Jurek

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Halla Yang

Citadel LLC

Date Written: April 2007

Abstract

This paper derives the optimal dynamic strategy for arbitrageurs with a finite horizon and non-myopic preferences facing a mean-reverting arbitrage opportunity (e.g. an equity pairs trade). We find that intertemporal hedging demands play an important role in determining how aggressively arbitrageurs trade against the mispricing and account for a large fraction of the total allocation to the arbitrage opportunity. While arbitrageurs typically bet against the mispricing, we analytically show that there is a critical level of mispricing beyond which further divergence precipitates a reduction in the allocation. When applied to Siamese twin shares our optimal strategy delivers a significant improvement in the realized Sharpe ratio and welfare relative to a simple threshold rule.

Keywords: arbitrage, law of one price, mean reversion, pairs trading, relative value, convergence

JEL Classification: G11, G12, G14

Suggested Citation

Jurek, Jakub W. and Yang, Halla, Dynamic Portfolio Selection in Arbitrage (April 2007). EFA 2006 Meetings Paper, Available at SSRN: https://ssrn.com/abstract=882536 or http://dx.doi.org/10.2139/ssrn.882536

Jakub W. Jurek (Contact Author)

University of Pennsylvania - Finance Department ( email )

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National Bureau of Economic Research (NBER)

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Halla Yang

Citadel LLC ( email )

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