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Optimal Convergence Trading

  • Vladislav Kargin

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://arxiv.org/pdf/math/0302104
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Paper provided by arXiv.org in its series Papers with number math/0302104.

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Date of creation: Feb 2003
Date of revision: Aug 2003
Handle: RePEc:arx:papers:math/0302104
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