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RFS Advance Access published online on October 15, 2003
Review of Financial Studies, doi:10.1093/rfs/hhg029
Review of Financial Studies © The Society for Financial Studies 2003; all rights reserved
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© 2003 The Society for Financial Studies

Original Articles

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

Jun Liu 1 and Francis A. Longstaff 2*
1 The Anderson School at UCLA
2 The Anderson School at UCLA; NBER

* To whom correspondence should be addressed. E-mail: francis.longstaff{at}anderson.ucla.edu.


  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.


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