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Optimal Pairs Trading with Time-Varying Volatility

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  • T. N. Li
  • A. Tourin

Abstract

We propose a pairs trading model that incorporates a time-varying volatility of the Constant Elasticity of Variance type. Our approach is based on stochastic control techniques; given a fixed time horizon and a portfolio of two co-integrated assets, we define the trading strategies as the portfolio weights maximizing the expected power utility from terminal wealth. We compute the optimal pairs strategies by using a Finite Difference method. Finally, we illustrate our results by conducting tests on historical market data at daily frequency. The parameters are estimated by the Generalized Method of Moments.

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  • T. N. Li & A. Tourin, 2021. "Optimal Pairs Trading with Time-Varying Volatility," Papers 2111.02834, arXiv.org.
    • Handle: RePEc:arx:papers:2111.02834
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    References listed on IDEAS

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    1. Tourin, Agnès & Yan, Raphael, 2013. "Dynamic pairs trading using the stochastic control approach," Journal of Economic Dynamics and Control, Elsevier, vol. 37(10), pages 1972-1981.
    2. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 33(1), pages 125-132.
    3. Stanley R. Pliska, 1986. "A Stochastic Calculus Model of Continuous Trading: Optimal Portfolios," Mathematics of Operations Research, INFORMS, vol. 11(2), pages 371-382, May.
    4. Minh Man Ngo & Huyen Pham, 2014. "Optimal switching for pairs trading rule: a viscosity solutions approach," Papers 1412.7649, arXiv.org.
    5. Jin-Yu Zhang & Yong Li & Zhu-Ming Chen, 2013. "Unit Root Hypothesis in the Presence of Stochastic Volatility, a Bayesian Analysis," Computational Economics, Springer;Society for Computational Economics, vol. 41(1), pages 89-100, January.
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