PAIRS TRADING UNDER DRIFT UNCERTAINTY AND RISK PENALIZATION

Sühan Altay (), Katia Colaneri () and Zehra Eksi ()
Additional contact information
Sühan Altay: Department of Financial and Actuarial Mathematics, Vienna University of Technology, Wiedner Hauptstrasse 8–10, 1040 Vienna, Austria
Katia Colaneri: School of Mathematics, University of Leeds, LS2 9JT Leeds, UK
Zehra Eksi: Institute for Statistics and Mathematics, WU-University of Economics and Business, Welthandelsplatz 1, 1020, Vienna, Austria

International Journal of Theoretical and Applied Finance (IJTAF), 2018, vol. 21, issue 07, 1-24

Abstract: In this work, we study a dynamic portfolio optimization problem related to pairs trading, which is an investment strategy that matches a long position in one security with a short position in another security with similar characteristics. The relationship between pairs, called a spread, is modeled by a Gaussian mean-reverting process whose drift rate is modulated by an unobservable continuous-time, finite-state Markov chain. Using the classical stochastic filtering theory, we reduce this problem with partial information to an equivalent one with full information and solve it for the logarithmic utility function, where the terminal wealth is penalized by the riskiness of the portfolio according to the realized volatility of the wealth process. We characterize optimal dollar-neutral strategies as well as optimal value functions under full and partial information and show that the certainty equivalence principle holds for the optimal portfolio strategy. Finally, we provide a numerical analysis for a toy example with a two-state Markov chain.

Keywords: Pairs trading; regime-switching; partial information (search for similar items in EconPapers)
Date: 2018
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S0219024918500462
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijtafx:v:21:y:2018:i:07:n:s0219024918500462

Ordering information: This journal article can be ordered from

DOI: 10.1142/S0219024918500462

Access Statistics for this article

International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

More articles in International Journal of Theoretical and Applied Finance (IJTAF) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().