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Pairs trading under delayed cointegration

Author

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  • Tingjin Yan
  • Mei Choi Chiu
  • Hoi Ying Wong

Abstract

Continuous-time pairs trading rules are often developed based on the diffusion limit of the first-order vector autoregressive (VAR(1)) cointegration models. Empirical identification of cointegration effects is generally made according to discrete-time error correction representation of vector autoregressive (VAR(p)) processes, allowing for delayed adjustment of the price deviation. Motivated by this, we investigate the continuous-time dynamic pairs trading problem under a class of path-dependent models. Under certain regular conditions, we prove the existence of the optimal strategy and show that it is related to a system of Riccati partial differential equations. The proof is developed by the means of functional Itô's calculus. We conduct a numerical study to analyze the sensitivities of the pairs trading strategy with respect to the initial market conditions and the memory length.

Suggested Citation

  • Tingjin Yan & Mei Choi Chiu & Hoi Ying Wong, 2022. "Pairs trading under delayed cointegration," Quantitative Finance, Taylor & Francis Journals, vol. 22(9), pages 1627-1648, September.
    • Handle: RePEc:taf:quantf:v:22:y:2022:i:9:p:1627-1648
    DOI: 10.1080/14697688.2022.2064760
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    Cited by:

    1. Yaoyuan Zhang & Dewen Xiong, 2023. "Optimal Strategy of the Dynamic Mean-Variance Problem for Pairs Trading under a Fast Mean-Reverting Stochastic Volatility Model," Mathematics, MDPI, vol. 11(9), pages 1-19, May.
    2. Yan, Tingjin & Chiu, Mei Choi & Wong, Hoi Ying, 2023. "Portfolio liquidation with delayed information," Economic Modelling, Elsevier, vol. 126(C).

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