Optimal Arbitrage under Limits to Arbitrage: The Case of Convergence Trade

50 Pages Posted: 19 Nov 2019 Last revised: 28 Nov 2019

See all articles by Jing Xu

Jing Xu

Renmin University of China - School of Finance

Date Written: November 8, 2019

Abstract

As a popular arbitrage strategy, convergence trade aims to exploit relative mispricing between two closely related assets. We examine optimal convergence trade strategies in the presence of three types of limits to arbitrage: short-selling cost, funding cost, and forced liquidation of investment positions. Our results show that the optimal allocation rules are piecewise linear functions of the mispricing level, allowing the trader to better balance the profits and costs incurred when she trades on mispricing. We also find that these limits to arbitrage have a stronger deterrence effect on short-selling than on purchasing, driving the optimal trading strategy significantly away from a delta-neutral one. Moreover, we find that it is optimal to liquidate positions on the convergence assets faster when the fund's termination risk increases.

Keywords: Pairs trading, Funding cost, Short-selling cost, Risky arbitrage

JEL Classification: C32, G11, G12

Suggested Citation

Xu, Jing, Optimal Arbitrage under Limits to Arbitrage: The Case of Convergence Trade (November 8, 2019). Available at SSRN: https://ssrn.com/abstract=3483425 or http://dx.doi.org/10.2139/ssrn.3483425

Jing Xu (Contact Author)

Renmin University of China - School of Finance ( email )

59 Zhongguancun Street
Beijing, 100872
China

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