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Pairs trading with costly short-selling

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  • Xu, Jing
  • Yang, Peiquan

Abstract

We study an optimal pairs trading model with costly short-selling. When the investor has logarithm utility function, we derive the solution in closed form, which shows that: the optimal allocation functions are piece-wise linear in the pair's relative price; stock borrowing fees asymmetrically reduce the optimal size of the long/short position; and for risk-hedging purpose, it can be optimal to short sell even when the stock borrowing fees outweigh the expected return earned from short selling. When the investor has power utility function, we propose analytical allocation functions adopting which only causes a small utility loss. When the investor is constrained from borrowing funds, the margin requirement for short selling can significantly affect the trading strategy. Empirically, we demonstrate the importance of incorporating short selling costs when trading pairs in China's stock market and verify the model-implied relation between short selling costs and profitability of pairs trading.

Suggested Citation

  • Xu, Jing & Yang, Peiquan, 2024. "Pairs trading with costly short-selling," Journal of Economic Dynamics and Control, Elsevier, vol. 168(C).
    • Handle: RePEc:eee:dyncon:v:168:y:2024:i:c:s0165188924001337
    DOI: 10.1016/j.jedc.2024.104941
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    References listed on IDEAS

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    More about this item

    Keywords

    Portfolio choice; Pairs trading; Risky arbitrage; Short selling cost;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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