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Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications

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  • Timmermann, Allan
  • Liu, Jun

Abstract

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.

Suggested Citation

  • Timmermann, Allan & Liu, Jun, 2009. "Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications," CEPR Discussion Papers 7188, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:7188
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    References listed on IDEAS

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    More about this item

    Keywords

    Cointegrated asset prices; Optimal portfolio choice; Risky arbitrage;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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