Abstract: When alphas are weak and rare, and arbitrageurs have to learn about alphas from historical data, there is a gap between Sharpe ratio that is feasible for them to achieve and the infeasible Sharpe ratio that could be obtained with perfect knowledge of parameters in the return generating process. This statistical limit to arbitrage widens the bounds within which alphas can survive in equilibrium relative to the arbitrage pricing theory (APT) in which arbitrageurs are endowed with perfect knowledge. We derive the optimal Sharpe ratio achievable by any feasible arbitrage strategy, and illustrate in a simple model how this Sharpe ratio varies with the strength and sparsity of alpha signals, which characterize the difficulty of arbitrageurs’ learning problem. Furthermore, we design an “all-weather” arbitrage strategy that achieves this optimal Sharpe ratio regardless of the conditions of alpha signals. Our empirical analysis of equity returns shows that this optimal strategy, along with other feasible strategies based on multiple-testing, LASSO, and Ridge methods, achieve a moderately low Sharpe ratio out of sample, in spite of a considerably higher infeasible Sharpe ratio, consistent with absence of feasible near-arbitrage opportunities and relevance of statistical limits to arbitrage.

Authors: Rui Da, Stefan Nagel, and Dacheng Xiu 

Bio:
Dacheng Xiu is Professor of Econometrics and Statistics at the University of Chicago Booth School of Business. His current research focuses on developing machine learning solutions to big-data problems in empirical finance. Xiu’s work has appeared in the Journal of Finance, Review of Financial Studies, Econometrica, Journal of Political Economy, the Journal of the American Statistical Association, and the Annals of Statistics. He is a Co-Editor for the Journal of Financial Econometrics, an Associate Editor for the Review of Financial Studies, Journal of the American Statistical Association, Journal of Econometrics, Management Science, etc. He has received several recognitions for his research, including the Fellow of the Society for Financial Econometrics, Fellow of the Journal of Econometrics, AQR Insight Award, EFA Best Paper Prize, and Swiss Finance Institute Outstanding Paper Award. At Booth, he teaches a variety of courses related to FinTech, Big Data, and Statistical Inference to MBA, college, and PhD students. Xiu earned his PhD and MA in applied mathematics from Princeton University.

Zoom:
https://us06web.zoom.us/j/81902742334?pwd=QTQ3T0VIeW5mUnRyUVZqbHMxYU43dz09
Zoom: 819 0274 2334
Password: 128211