Optimal convergence trading with unobservable pricing errors

Sühan Altay (), Katia Colaneri () and Zehra Eksi ()
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Sühan Altay: WU-University of Economics and Business
Katia Colaneri: University of Rome Tor Vergata
Zehra Eksi: WU-University of Economics and Business

Annals of Operations Research, 2021, vol. 299, issue 1, No 8, 133-161

Abstract: Abstract We study a dynamic portfolio optimization problem related to convergence trading, which is an investment strategy that exploits temporary mispricing by simultaneously buying relatively underpriced assets and selling short relatively overpriced ones with the expectation that their prices converge in the future. We build on the model of Liu and Timmermann (Rev Financ Stud 26(4):1048–1086, 2013) and extend it by incorporating unobservable Markov-modulated pricing errors into the price dynamics of two co-integrated assets. We characterize the optimal portfolio strategies in full and partial information settings under the assumption of unrestricted and beta-neutral strategies. By using the innovations approach, we provide the filtering equation which is essential for solving the optimization problem under partial information. Finally, in order to illustrate the model capabilities, we provide an example with a two-state Markov chain.

Keywords: Optimal control; Convergence trade; Regime-switching; Partial information (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1007/s10479-020-03647-z

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