Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications

Allan Timmermann and Jun Liu

No 7188, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Cointegrated asset prices; Optimal portfolio choice; Risky arbitrage (search for similar items in EconPapers)
JEL-codes: G11 (search for similar items in EconPapers)
Date: 2009-03
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