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Optimal pairs trading with time-varying volatility

Author

Listed:
  • Thomas Nanfeng Li

    () (Department of Mathematics, New York University Tandon School of Engineering, Six Metrotech Center, Brooklyn, NY 11201, USA)

  • Agnès Tourin

    (#x2020;Department of Finance and Risk Engineering, New York University Tandon School of Engineering, Six Metrotech Center, Brooklyn, NY 11201, USA)

Abstract

In this paper, we propose a pairs trading model that incorporates a time-varying volatility of the constant elasticity of variance type. Our approach is based on stochastic control techniques; given a fixed time horizon and a portfolio of two cointegrated assets, we define the trading strategies as the portfolio weights maximizing the expected power utility from terminal wealth. We compute the optimal pairs strategies by using a finite difference method. Finally, we illustrate our results by conducting tests on historical market data at daily frequency. The parameters are estimated by the generalized method of moments.

Suggested Citation

  • 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.
  • Handle: RePEc:wsi:ijfexx:v:03:y:2016:i:03:n:s2424786316500237
    DOI: 10.1142/S2424786316500237
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    References listed on IDEAS

    as
    1. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-1054, July.
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    9. Stanley R. Pliska, 1986. "A Stochastic Calculus Model of Continuous Trading: Optimal Portfolios," Mathematics of Operations Research, INFORMS, vol. 11(2), pages 371-382, May.
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