Losing Money on Arbitrage: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities
University of California, San Diego (UCSD) - Rady School of Management
Francis A. Longstaff
University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)
AFA 2001 New Orleans; EFMA 2000 Athens; UCLA Finance Working Paper No. 9-00
In theory, an investor can make infinite profits by taking unlimited positions in an arbitrage. In reality, however, investors must satisfy margin requirements which completely change the economics of arbitrage. We derive the optimal investment policy for a risk-averse investor in a market where there are arbitrage opportunities. We show that is is often optimal to underinvest in the arbitrage by taking a smaller position than margin constraints allow. In some cases, it is actually optimal for an investor to walk away from a pure arbitrage opportunity. Even when the optimal policy is followed, the arbitrage strategy may underperform the riskless asset to have an unimpressive Sharpe ratio. Furthermore, the arbitrage portfolio typically experiences losses at some point before the final convergence date. These results have important implications for the role of arbitrageurs in financial markets.
Number of Pages in PDF File: 61
Keywords: Arbitrage, margin requirements, optimal portfolio
JEL Classification: D9, G0, G1working papers series
Date posted: December 11, 2000
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