Optimal Pairs Trading with Time-Varying Volatility

T. N. Li and A. Tourin

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Abstract: 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 co-integrated 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.

Date: 2021-11
New Economics Papers: this item is included in nep-ore and nep-upt
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