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Optimal Convergence Trading

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Author Info
Vladislav KArgin

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Abstract

This article examines arbitrage investment in a mispriced asset when the mispricing follows the Ornstein-Uhlenbeck process and a credit- constrained investor maximizes a generalization of the Kelly criterion. The optimal differentiable and threshold policies are derived. The optimal differentiable policy is linear with respect to mispricing and risk-free in the long run. The optimal threshold policy calls for investing immediately when the mispricing is greater than zero with the investment amount inversely proportional to the risk aversion parameter. The investment is risky even in the long run. The results are consistent with the belief that credit-constrained arbitrageurs should be risk- neutral if they are to engage in convergence trading.

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File URL: http://129.3.20.41/eps/fin/papers/0401/0401003.pdf
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Publisher Info
Paper provided by EconWPA in its series Finance with number 0401003.

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Length: 24 pages
Date of creation: 14 Jan 2004
Date of revision:
Handle: RePEc:wpa:wuwpfi:0401003

Note: Type of Document - pdf; prepared on Win2000; pages: 24; figures: 6
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Web page: http://129.3.20.41

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Related research
Keywords: arbitrage; leverage; investment strategy;

Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

This paper has been announced in the following NEP Reports:

References listed on IDEAS
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    Other versions:
  4. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September. [Downloadable!] (restricted)
  5. Sanford J. Grossman & Jean-Juc Vila, . "Optimal Dynamic Trading with Leverage Constraints," Rodney L. White Center for Financial Research Working Papers 36-89, Wharton School Rodney L. White Center for Financial Research.
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  7. John Y. Campbell & Luis M. Viceira, 1999. "Consumption And Portfolio Decisions When Expected Returns Are Time Varying," The Quarterly Journal of Economics, MIT Press, vol. 114(2), pages 433-495, May. [Downloadable!] (restricted)
    Other versions:
  8. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August. [Downloadable!] (restricted)
  9. Jun Liu & Francis Longstaff, 2000. "Losing Money on Arbitrages: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities," University of California at Los Angeles, Anderson Graduate School of Management 1054, Anderson Graduate School of Management, UCLA. [Downloadable!]
  10. Wachter, Jessica A., 2002. "Portfolio and Consumption Decisions under Mean-Reverting Returns: An Exact Solution for Complete Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 63-91, March. [Downloadable!]
  11. Grossman, Sanford J. & Vila, Jean-Luc, 1992. "Optimal Dynamic Trading with Leverage Constraints," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(02), pages 151-168, June. [Downloadable!]
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