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Optimal Convergence Trading

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Author Info

  • Vladislav KArgin

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://128.118.178.162/eps/fin/papers/0401/0401003.pdf
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Bibliographic 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://128.118.178.162

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Keywords: arbitrage; leverage; investment strategy;

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References

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  1. 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.
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Cited by:
  1. Yingdong Lv & Bernhard K. Meister, 2009. "Application of the Kelly Criterion to Ornstein-Uhlenbeck Processes," Papers 0903.2910, arXiv.org.

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