DP7188 Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications
|Author(s):||Jun Liu, Allan Timmermann|
|Publication Date:||March 2009|
|Keyword(s):||cointegrated asset prices, optimal portfolio choice, risky arbitrage|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=7188|
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.