Monte Carlo Simulation for Trading Under a Lévy-Driven Mean-Reverting Framework

Tim Leung and Kevin W. Lu

Applied Mathematical Finance, 2023, vol. 30, issue 4, 207-230

Abstract: We present a Monte Carlo approach to pairs trading on mean-reverting spreads modelled by Lévy-driven Ornstein-Uhlenbeck processes. Specifically, we focus on using a variance gamma driving process, an infinite activity pure jump process to allow for more flexible models of the price spread than is available in the classical model. However, this generalization comes at the cost of not having analytic formulas, so we apply Monte Carlo methods to determine optimal trading levels and develop a variance reduction technique using control variates. Within this framework, we numerically examine how the optimal trading strategies are affected by the parameters of the model. In addition, we extend our method to bivariate spreads modelled using a weak variance alpha-gamma driving process, and explore the effect of correlation on these trades.

Date: 2023
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Working Paper: Monte Carlo Simulation for Trading Under a L\'evy-Driven Mean-Reverting Framework (2024)
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DOI: 10.1080/1350486X.2024.2316139

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