Portfolio optimization for cointelated pairs: SDEs vs Machine learning

DOI10.3233/AF-200311MaRDI QIDQ5156840zbMATH OpenOpenAlexFDO

Authors

Publication date 12 October 2021

Published in Algorithmic Finance (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1812.10183

zbMATH Keywords

band-wise Gaussian mixturecointelationdeep learningpairs tradingportfolio optimizationstochastic control

Mathematics Subject Classification ID

Artificial neural networks and deep learning (68T07) Portfolio theory (91G10)

Abstract: With the recent rise of Machine Learning as a candidate to partially replace classic Financial Mathematics methodologies, we investigate the performances of both in solving the problem of dynamic portfolio optimization in continuous-time, finite-horizon setting for a portfolio of two assets that are intertwined. In Financial Mathematics approach we model the asset prices not via the common approaches used in pairs trading such as a high correlation or cointegration, but with the cointelation model that aims to reconcile both short-term risk and long-term equilibrium. We maximize the overall P&L with Financial Mathematics approach that dynamically switches between a mean-variance optimal strategy and a power utility maximizing strategy. We use a stochastic control formulation of the problem of power utility maximization and solve numerically the resulting HJB equation with the Deep Galerkin method. We turn to Machine Learning for the same P&L maximization problem and use clustering analysis to devise bands, combined with in-band optimization. Although this approach is model agnostic, results obtained with data simulated from the same cointelation model as FM give an edge to ML.

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Cited in

(1)

• Short-term sparse portfolio optimization based on alternating direction method of multipliers

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