Dynamic Portfolio Selection in Arbitrage

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Abstract
This paper derives the optimal dynamic strategy for arbitrageurs with a finite horizon and non-myopic preferences facing a mean-reverting arbitrage opportunity (e.g. an equity pairs trade). We find that intertemporal hedging demands play an important role in determining how aggressively arbitrageurs trade against the mispricing and account for a large fraction of the total allocation to the arbitrage opportunity. While arbitrageurs typically bet against the mispricing, we analytically show that there is a critical level of mispricing beyond which further divergence precipitates a reduction in the allocation. When applied to Siamese twin shares our optimal strategy delivers a significant improvement in the realized Sharpe ratio and welfare relative to a simple threshold rule.

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