Optimal portfolio selection in nonlinear arbitrage spreads

Abstract

This paper analytically solves the portfolio optimization problem of an investor faced with a risky arbitrage opportunity (e.g. relative mispricing in equity pairs). Unlike the extant literature, which typically models mispricings through the Ornstein–Uhlenbeck (OU) process, we introduce a nonlinear generalization of OU which jointly captures several important risk factors inherent in arbitrage trading. While these factors are absent from the standard OU, we show that considering them yields several new insights into the behavior of rational arbitrageurs: Firstly, arbitrageurs recognizing these risk factors exhibit a diminishing propensity to exploit large mispricings. Secondly, optimal investment behavior in light of these risk factors precipitates the gradual unwinding of losing trades far sooner than is entailed in existing approaches including OU. Finally, an empirical application to daily FTSE100 pairs data shows that incorporating these risks renders our model's risk-management capabilities superior to both OU and a simple threshold strategy popular in the literature. These observations are useful in understanding the role of arbitrageurs in enforcing price efficiency.