Losing Money on Arbitrage: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities (2024)

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Volume 17 Issue 3 July 2004
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Jun Liu

UCLA

Address correspondence to Francis A. Longstaff, Anderson School, UCLA, 110 Westwood Plaza, Los Angeles, CA 90095-1481, or e-mail: francis.longstaff@anderson.ucla.edu

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Francis A. Longstaff

UCLA and NBER

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The Review of Financial Studies, Volume 17, Issue 3, July 2004, Pages 611–641, https://doi.org/10.1093/rfs/hhg029

Published:

15 October 2003

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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.

The Review of Financial Studies Vol. 17, No. 3 © 2004 The Society for Financial Studies; all rights reserved.

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