Pairs trading under drift uncertainty and risk penalization
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Publication:4555856
DOI10.1142/S0219024918500462zbMATH Open1417.91430arXiv1704.06697MaRDI QIDQ4555856FDOQ4555856
Authors: Sühan Altay, Katia Colaneri, Zehra Eksi 
Publication date: 23 November 2018
Published in: International Journal of Theoretical and Applied Finance (Search for Journal in Brave)
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.
Full work available at URL: https://arxiv.org/abs/1704.06697
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Signal detection and filtering (aspects of stochastic processes) (60G35) Portfolio theory (91G10) Optimal stochastic control (93E20)
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