Pairs trading under drift uncertainty and risk penalization
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Publication:4555856
Abstract: In this work, we study a dynamic portfolio optimization problem related to pairs trading, which is an investment strategy that matches a long position in one security with a short position in another security with similar characteristics. The relationship between pairs, called a spread, is modeled by a Gaussian mean-reverting process whose drift rate is modulated by an unobservable continuous-time, finite-state Markov chain. Using the classical stochastic filtering theory, we reduce this problem with partial information to the one with full information and solve it for the logarithmic utility function, where the terminal wealth is penalized by the riskiness of the portfolio according to the realized volatility of the wealth process. We characterize optimal dollar-neutral strategies as well as optimal value functions under full and partial information and show that the certainty equivalence principle holds for the optimal portfolio strategy. Finally, we provide a numerical analysis for a toy example with a two-state Markov chain.
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Cited in
(8)- Implicit incentives for fund managers with partial information
- Pairs trading of two assets with uncertainty in co-integration's level of mean reversion
- A flexible regime switching model with pairs trading application to the S\&P 500 high-frequency stock returns
- The value of knowing the market price of risk
- Stochastic filtering of a pure jump process with predictable jumps and path-dependent local characteristics
- TRADING MULTIPLE MEAN REVERSION
- Bertram's pairs trading strategy with bounded risk
- Optimal convergence trading with unobservable pricing errors
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