Quotation Altay, Sühan, Colaneri, Katia, Eksi-Altay, Zehra. 2018. Pairs Trading under Drift Uncertainty and Risk Penalization. International Journal of Theoretical and Applied Finance. 21 (07), 1850046




this work, we study a dynamic portfolio optimization problem related to pairs trading, which is an investment strategy that matches a long position in one security with a short position in another security with similar characteristics. The relationship between pairs, called a spread, is modeled by a Gaussian mean-reverting process whose drift rate is modulated by an unobservable continuous-time, finite-state Markov chain. Using the classical stochastic filtering theory, we reduce this problem with partial information to an equivalent one with full information and solve it for the logarithmic utility function, where the terminal wealth is penalized by the riskiness of the portfolio according to the realized volatility of the wealth process. We characterize optimal dollar-neutral strategies as well as optimal value functions under full and partial information and show that the certainty equivalence principle holds for the optimal portfolio strategy. Finally, we provide a numerical analysis for a toy example with a two-state Markov chain.


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Publication's profile

Status of publication Published
Affiliation WU
Type of publication Journal article
Journal International Journal of Theoretical and Applied Finance
WU Journalrating 2009 A
WU-Journal-Rating new FIN-A, STRAT-B, VW-D, WH-B
Language English
Title Pairs Trading under Drift Uncertainty and Risk Penalization
Volume 21
Number 07
Year 2018
Page from 1850046
Reviewed? Y
URL https://www.worldscientific.com/doi/abs/10.1142/S0219024918500462
DOI http://dx.doi.org/10.1142/S0219024918500462
Open Access N


Altay, Sühan (Details)
Eksi-Altay, Zehra (Details)
Colaneri, Katia (University of Leeds, United Kingdom)
Institute for Statistics and Mathematics IN (Details)
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