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Costly arbitrage through pairs trading

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  • Lei, Yaoting
  • Xu, Jing

Abstract

We study the optimal trading policy of an arbitrageur who can exploit temporary mispricing in a market with two convergent assets. We build on the model of Liu and Timmermann (2013) and include transaction costs, which impose additional limits to the implementation of such convergence trade strategy. We show that the presence of transaction costs could reveal an endogenous stop-loss concern in a certain economy, which affects the optimal policy of the arbitrageur in significant ways. Using pairs of dual-listed Chinese stock shares as samples and a pairs trading strategy based on standard deviation of the spread as benchmark, we demonstrate the efficiency of the strategy implied by our model. Several extensions of our model are also discussed.

Suggested Citation

  • Lei, Yaoting & Xu, Jing, 2015. "Costly arbitrage through pairs trading," Journal of Economic Dynamics and Control, Elsevier, vol. 56(C), pages 1-19.
    • Handle: RePEc:eee:dyncon:v:56:y:2015:i:c:p:1-19
    DOI: 10.1016/j.jedc.2015.04.006
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    References listed on IDEAS

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    2. Tourin, Agnès & Yan, Raphael, 2013. "Dynamic pairs trading using the stochastic control approach," Journal of Economic Dynamics and Control, Elsevier, vol. 37(10), pages 1972-1981.
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    6. Broussard, John Paul & Vaihekoski, Mika, 2012. "Profitability of pairs trading strategy in an illiquid market with multiple share classes," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(5), pages 1188-1201.
    7. Brennan, Michael J & Schwartz, Eduardo S, 1990. "Arbitrage in Stock Index Futures," The Journal of Business, University of Chicago Press, vol. 63(1), pages 7-31, January.
    8. Robert Elliott & John Van Der Hoek & William Malcolm, 2005. "Pairs trading," Quantitative Finance, Taylor & Francis Journals, vol. 5(3), pages 271-276.
    9. Duan, Jin-Chuan & Pliska, Stanley R., 2004. "Option valuation with co-integrated asset prices," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 727-754, January.
    10. Masaki Mori & Alan J. Ziobrowski, 2011. "Performance of Pairs Trading Strategy in the U.S. REIT Market," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 39(3), pages 409-428, September.
    11. Chiu, Mei Choi & Wong, Hoi Ying, 2011. "Mean-variance portfolio selection of cointegrated assets," Journal of Economic Dynamics and Control, Elsevier, vol. 35(8), pages 1369-1385, August.
    12. Dai, Min & Kwok, Yue Kuen & You, Hong, 2007. "Intensity-based framework and penalty formulation of optimal stopping problems," Journal of Economic Dynamics and Control, Elsevier, vol. 31(12), pages 3860-3880, December.
    13. Perlin, M., 2007. "Evaluation of pairs trading strategy at the Brazilian financial market," MPRA Paper 8308, University Library of Munich, Germany.
    14. Jun Liu & Allan Timmermann, 2013. "Optimal Convergence Trade Strategies," Review of Financial Studies, Society for Financial Studies, vol. 26(4), pages 1048-1086.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Alvaro Cartea & Luhui Gan & Sebastian Jaimungal, 2018. "Trading Cointegrated Assets with Price Impact," Papers 1807.01428, arXiv.org.
    2. Haipeng Xing, 2019. "A singular stochastic control approach for optimal pairs trading with proportional transaction costs," Papers 1911.10450, arXiv.org.
    3. Haipeng Xing, 2022. "A Singular Stochastic Control Approach for Optimal Pairs Trading with Proportional Transaction Costs," JRFM, MDPI, vol. 15(4), pages 1-23, March.
    4. Sühan Altay & Katia Colaneri & Zehra Eksi, 2021. "Optimal convergence trading with unobservable pricing errors," Annals of Operations Research, Springer, vol. 299(1), pages 133-161, April.
    5. P. S. Lintilhac & A. Tourin, 2017. "Model-based pairs trading in the bitcoin markets," Quantitative Finance, Taylor & Francis Journals, vol. 17(5), pages 703-716, May.
    6. Guang Zhang, 2020. "Pairs Trading with Nonlinear and Non-Gaussian State Space Models," Papers 2005.09794, arXiv.org.
    7. Suhan Altay & Katia Colaneri & Zehra Eksi, 2019. "Optimal Convergence Trading with Unobservable Pricing Errors," Papers 1910.01438, arXiv.org, revised Oct 2019.
    8. Krauss, Christopher, 2015. "Statistical arbitrage pairs trading strategies: Review and outlook," FAU Discussion Papers in Economics 09/2015, Friedrich-Alexander University Erlangen-Nuremberg, Institute for Economics.
    9. Zequn Li & Agnès Tourin, 2022. "A Finite Difference Scheme for Pairs Trading with Transaction Costs," Computational Economics, Springer;Society for Computational Economics, vol. 60(2), pages 601-632, August.
    10. Suhan Altay & Katia Colaneri & Zehra Eksi, 2017. "Pairs Trading under Drift Uncertainty and Risk Penalization," Papers 1704.06697, arXiv.org, revised Sep 2018.
    11. Thomas Nanfeng Li & Agnès Tourin, 2016. "Optimal pairs trading with time-varying volatility," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 3(03), pages 1-29, September.
    12. Sühan Altay & Katia Colaneri & Zehra Eksi, 2018. "Pairs Trading Under Drift Uncertainty And Risk Penalization," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(07), pages 1-24, November.
    13. Álvaro Cartea & Sebastian Jaimungal, 2016. "Algorithmic Trading Of Co-Integrated Assets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(06), pages 1-18, September.
    14. Fernando Caneo & Werner Kristjanpoller, 2021. "Improving statistical arbitrage investment strategy: Evidence from Latin American stock markets," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(3), pages 4424-4440, July.
    15. T. N. Li & A. Papanicolaou, 2019. "Statistical Arbitrage for Multiple Co-Integrated Stocks," Papers 1908.02164, arXiv.org, revised Feb 2022.

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    More about this item

    Keywords

    Pairs trading; Risky arbitrage; Delta-neutral strategies; Transaction costs;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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