IDEAS home Printed from https://ideas.repec.org/a/oup/rfinst/v17y2004i3p611-641.html
   My bibliography  Save this article

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

Author

Listed:
  • Jun Liu

Abstract

We derive the optimal investment policy of a risk-averse investor in a market where there is a textbook arbitrage opportunity, but where liabilities must be secured by collateral. We find that it is often optimal to underinvest in the arbitrage by taking a smaller position than collateral constraints allow. Even when the optimal policy is followed, the arbitrage portfolio typically experiences losses before the final convergence date. In fact, its initial performance may be indistinguishable from that of a conventional portfolio with a poor track record. These results have important implications for the role of arbitrageurs in financial markets. Copyright 2004, Oxford University Press.

Suggested Citation

  • Jun Liu, 2004. "Losing Money on Arbitrage: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities," The Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 611-641.
    • Handle: RePEc:oup:rfinst:v:17:y:2004:i:3:p:611-641
    as

    Download full text from publisher

    File URL: http://hdl.handle.net/10.1093/rfs/hhg029
    Download Restriction: Access to full text is restricted to subscribers.
    ---><---

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    1. Philip H. Dybvig, Chi-fu Huang, 1988. "Nonnegative Wealth, Absence of Arbitrage, and Feasible Consumption Plans," The Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 377-401.
    2. John H. Cochrane & Jesus Saa-Requejo, 2000. "Beyond Arbitrage: Good-Deal Asset Price Bounds in Incomplete Markets," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 79-119, February.
    3. Longstaff, Francis A, 1995. "Option Pricing and the Martingale Restriction," The Review of Financial Studies, Society for Financial Studies, vol. 8(4), pages 1091-1124.
    4. Basak, Suleyman & Croitoru, Benjamin, 2000. "Equilibrium Mispricing in a Capital Market with Portfolio Constraints," The Review of Financial Studies, Society for Financial Studies, vol. 13(3), pages 715-748.
    5. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
    6. Willard, Gregory A & Dybvig, Philip H, 1999. "Empty Promises and Arbitrage," The Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 807-834.
    7. Hindy, Ayman, 1995. "Viable prices in financial markets with solvency constraints," Journal of Mathematical Economics, Elsevier, vol. 24(2), pages 105-135.
    8. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
    9. Mark Grinblatt & Francis A. Longstaff, 2000. "Financial Innovation and the Role of Derivative Securities: An Empirical Analysis of the Treasury STRIPS Program," Journal of Finance, American Finance Association, vol. 55(3), pages 1415-1436, June.
    10. Brennan, Michael J & Schwartz, Eduardo S, 1990. "Arbitrage in Stock Index Futures," The Journal of Business, University of Chicago Press, vol. 63(1), pages 7-31, January.
    11. Shleifer, Andrei & Vishny, Robert W, 1997. "The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
    12. Jean-Pierre Zigrand, 1999. "Arbitrage and Endogenous Market Integration," FMG Discussion Papers dp319, Financial Markets Group.
    13. Ball, Clifford A. & Torous, Walter N., 1983. "Bond Price Dynamics and Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 18(4), pages 517-531, December.
    14. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
    15. Chen Zhiwu, 1995. "Financial Innovation and Arbitrage Pricing in Frictional Economies," Journal of Economic Theory, Elsevier, vol. 65(1), pages 117-135, February.
    16. Carl Ackermann & Richard McEnally & David Ravenscraft, 1999. "The Performance of Hedge Funds: Risk, Return, and Incentives," Journal of Finance, American Finance Association, vol. 54(3), pages 833-874, June.
    17. Dumas, Bernard, 1992. "Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World," The Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 153-180.
    18. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
    19. Cheng, Susan T., 1991. "On the feasibility of arbitrage-based option pricing when stochastic bond price processes are involved," Journal of Economic Theory, Elsevier, vol. 53(1), pages 185-198, February.
    20. Fung, William & Hsieh, David A, 1997. "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds," The Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 275-302.
    21. Tuckman, Bruce & Vila, Jean-Luc, 1992. "Arbitrage with Holding Costs: A Utility-Based Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1283-1302, September.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    2. Hardy Hulley, 2009. "Strict Local Martingales in Continuous Financial Market Models," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 19, July-Dece.
    3. Hardy Hulley, 2009. "Strict Local Martingales in Continuous Financial Market Models," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 2-2009, January-A.
    4. Leonid Kogan & Stephen A. Ross & Jiang Wang & Mark M. Westerfield, 2006. "The Price Impact and Survival of Irrational Traders," Journal of Finance, American Finance Association, vol. 61(1), pages 195-229, February.
    5. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
    6. Nicolae Garleanu & Lasse Heje Pedersen & Allen M. Poteshman, 2009. "Demand-Based Option Pricing," The Review of Financial Studies, Society for Financial Studies, vol. 22(10), pages 4259-4299, October.
    7. Jaime A. Londo~no, 2003. "State Tameness: A New Approach for Credit Constrains," Papers math/0305274, arXiv.org, revised Feb 2004.
    8. Suresh M. Sundaresan, 2000. "Continuous‐Time Methods in Finance: A Review and an Assessment," Journal of Finance, American Finance Association, vol. 55(4), pages 1569-1622, August.
    9. Duffie, Darrell, 2003. "Intertemporal asset pricing theory," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 11, pages 639-742, Elsevier.
    10. Gibson, Rajna & Lhabitant, Francois-Serge & Talay, Denis, 2010. "Modeling the Term Structure of Interest Rates: A Review of the Literature," Foundations and Trends(R) in Finance, now publishers, vol. 5(1–2), pages 1-156, December.
    11. repec:dau:papers:123456789/5374 is not listed on IDEAS
    12. John Y. Campbell, 2000. "Asset Pricing at the Millennium," Journal of Finance, American Finance Association, vol. 55(4), pages 1515-1567, August.
    13. Eli Ofek & Matthew Richardson & Robert F. Whitelaw, 2003. "Limited Arbitrage and Short Sales Restrictions: Evidence from the Options Markets," NBER Working Papers 9423, National Bureau of Economic Research, Inc.
    14. Mondher Bellalah, 2009. "Derivatives, Risk Management & Value," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 7175, December.
    15. K. Nawalkha, Sanjay, 1995. "Face value convergence for stochastic bond price processes: a note on Merton's partial equilibrium option pricing model," Journal of Banking & Finance, Elsevier, vol. 19(1), pages 153-164, April.
    16. René Garcia & Richard Luger & Eric Renault, 2000. "Asymmetric Smiles, Leverage Effects and Structural Parameters," Working Papers 2000-57, Center for Research in Economics and Statistics.
    17. René M. Stulz, 2007. "Hedge Funds: Past, Present, and Future," Journal of Economic Perspectives, American Economic Association, vol. 21(2), pages 175-194, Spring.
    18. Bjork, Tomas, 2009. "Arbitrage Theory in Continuous Time," OUP Catalogue, Oxford University Press, edition 3, number 9780199574742.
    19. Saggese, Pietro & Belmonte, Alessandro & Dimitri, Nicola & Facchini, Angelo & Böhme, Rainer, 2023. "Arbitrageurs in the Bitcoin ecosystem: Evidence from user-level trading patterns in the Mt. Gox exchange platform," Journal of Economic Behavior & Organization, Elsevier, vol. 213(C), pages 251-270.
    20. Ait-Sahalia, Yacine & Lo, Andrew W., 2000. "Nonparametric risk management and implied risk aversion," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 9-51.
    21. Ibáñez, Alfredo, 2008. "Factorization of European and American option prices under complete and incomplete markets," Journal of Banking & Finance, Elsevier, vol. 32(2), pages 311-325, February.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:oup:rfinst:v:17:y:2004:i:3:p:611-641. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Oxford University Press (email available below). General contact details of provider: https://edirc.repec.org/data/sfsssea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.