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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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    References listed on IDEAS

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    Cited by:

    1. Sühan Altay & Katia Colaneri & Zehra Eksi, 2021. "Optimal convergence trading with unobservable pricing errors," Annals of Operations Research, Springer, vol. 299(1), pages 133-161, April.
    2. Tim Leung & Raphael Yan, 2018. "Optimal dynamic pairs trading of futures under a two-factor mean-reverting model," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 5(03), pages 1-23, September.
    3. Xiaodong Chen & Tim Leung & Yang Zhou, 2022. "Constrained dynamic futures portfolios with stochastic basis," Annals of Finance, Springer, vol. 18(1), pages 1-33, March.
    4. Abdelali Gabih & Hakam Kondakji & Ralf Wunderlich, 2022. "Well Posedness of Utility Maximization Problems Under Partial Information in a Market with Gaussian Drift," Papers 2205.08614, arXiv.org, revised Jul 2024.
    5. Zequn Li & Agnès Tourin, 2022. "A Finite Difference Scheme for Pairs Trading with Transaction Costs," Computational Economics, Springer;Society for Computational Economics, vol. 60(2), pages 601-632, August.
    6. Suhan Altay & Katia Colaneri & Zehra Eksi, 2019. "Optimal Convergence Trading with Unobservable Pricing Errors," Papers 1910.01438, arXiv.org, revised Oct 2019.

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