Costly arbitrage through pairs trading

We study the optimal trading policy of an arbitrageur who can exploit temporary mispricing in a market with two convergent assets. We build on the model of Liu and Timmermann (2013) and include transaction costs, which impose additional limits to the implementation of such convergence trade strategy. We show that the presence of transaction costs could reveal an endogenous stop-loss concern in a certain economy, which affects the optimal policy of the arbitrageur in significant ways. Using pairs of dual-listed Chinese stock shares as samples and a pairs trading strategy based on standard deviation of the spread as benchmark, we demonstrate the efficiency of the strategy implied by our model. Several extensions of our model are also discussed.