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On the Market-Neutrality of Optimal Pairs-Trading Strategies

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  • Bahman Angoshtari

Abstract

We consider the problem of optimal investment in a market with two cointegrated stocks and an agent with CRRA utility. We extend the findings of Liu and Timmermann [The Review of Financial Studies, 26(4):1048-1086, 2013] by paying special attention to when/if the associated stochastic control problem is well-posed and providing a verification result. Our new findings lead to a sharp well-posedness condition which is, surprisingly, also the necessary and sufficient condition for the optimal investment to be market-neutral (i.e. having offsetting long/short positions in the stocks). Hence, we provide a theoretical justification for market-neutral pairs-trading which, despite having a strong practical relevance, has been lacking a theoretical ground.

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  • Bahman Angoshtari, 2016. "On the Market-Neutrality of Optimal Pairs-Trading Strategies," Papers 1608.08268, arXiv.org.
  • Handle: RePEc:arx:papers:1608.08268
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