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
JEL(s): G11
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.