Optimal pairs trading with time-varying volatility

Thomas Nanfeng Li () and Agnès Tourin
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Thomas Nanfeng Li: Department of Mathematics, New York University Tandon School of Engineering, Six Metrotech Center, Brooklyn, NY 11201, USA
Agnès Tourin: #x2020;Department of Finance and Risk Engineering, New York University Tandon School of Engineering, Six Metrotech Center, Brooklyn, NY 11201, USA

International Journal of Financial Engineering (IJFE), 2016, vol. 03, issue 03, 1-29

Abstract: In this paper, we propose a pairs trading model that incorporates a time-varying volatility of the constant elasticity of variance type. Our approach is based on stochastic control techniques; given a fixed time horizon and a portfolio of two cointegrated assets, we define the trading strategies as the portfolio weights maximizing the expected power utility from terminal wealth. We compute the optimal pairs strategies by using a finite difference method. Finally, we illustrate our results by conducting tests on historical market data at daily frequency. The parameters are estimated by the generalized method of moments.

Keywords: Stochastic control; pairs trading; cointegration; constant elasticity of variance; statistical arbitrage (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (3)

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DOI: 10.1142/S2424786316500237

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