Optimal Convergence Trading

Vladislav Kargin ()

Finance from EconWPA

Abstract: This article examines arbitrage investment in a mispriced asset when the mispricing follows the Ornstein-Uhlenbeck process and a credit- constrained investor maximizes a generalization of the Kelly criterion. The optimal differentiable and threshold policies are derived. The optimal differentiable policy is linear with respect to mispricing and risk-free in the long run. The optimal threshold policy calls for investing immediately when the mispricing is greater than zero with the investment amount inversely proportional to the risk aversion parameter. The investment is risky even in the long run. The results are consistent with the belief that credit-constrained arbitrageurs should be risk- neutral if they are to engage in convergence trading.

Keywords: arbitrage; leverage; investment strategy (search for similar items in EconPapers)
JEL-codes: G11 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fin
Date: 2004-01-14
Note: Type of Document - pdf; prepared on Win2000; pages: 24; figures: 6
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:0401003

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