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Rev Fin 2004; 17:611-641
The Review of Financial Studies Vol. 17, No. 3 © 2004 The Society for Financial Studies; all rights reserved.

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

Jun Liu
UCLA

Francis A. Longstaff
UCLA and NBER

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

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.


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