Statistical Arbitrage and Securities Prices
Review of Financial Studies, Vol. 16, p. 875-919, 2003
44 Pages Posted: 19 Aug 2002 Last revised: 3 Nov 2014
Date Written: May 10, 2002
This paper introduces the concept of a statistical arbitrage opportunity (SAO). In a finite-horizon economy, an SAO is a zero-cost trading strategy for which i) the expected payoff is positive, and ii) the conditional expected payoff in each final state of the economy is nonnegative. Unlike a pure arbitrage opportunity, an SAO can have negative payoffs provided that the average payoff in each final state is nonnegative. If the pricing kernel in the economy is path-independent then no SAOs can exist. Furthermore, ruling out SAOs imposes a novel martingale-type restriction on the dynamics of securities prices. The important properties of the restriction are that it 1) is model-free, in the sense that it requires no parametric assumptions about the true equilibrium model, 2) can be tested in samples affected by selection biases, such as the Peso problem, and 3) continues to hold when investors' beliefs are mistaken. The paper argues that one can use the new restriction to empirically resolve the joint hypothesis problem present in the traditional tests of the Efficient Market Hypothesis.
Keywords: Arbitrage, Pricing Kernel, Market Efficiency Hypothesis, Rational Learning, Option Valuation, Risk-Neutral Density, Peso problem
JEL Classification: D84, G12, G13, G14
Suggested Citation: Suggested Citation