Dynamic cointegrated pairs trading: Mean-variance time-consistent strategies

Mei Choi CHIU, Hoi Ying WONG

Research output: Contribution to journalArticles

12 Citations (Scopus)

Abstract

Cointegration is a useful econometric tool for identifying assets which share a common equilibrium. Cointegrated pairs trading is a trading strategy which attempts to take a profit when cointegrated assets depart from their equilibrium. This paper investigates the optimal dynamic trading of cointegrated assets using the classical mean-variance portfolio selection criterion. To ensure rational economic decisions, the optimal strategy is obtained over the set of time-consistent policies from which the optimization problem is enforced to obey the dynamic programming principle. We solve the optimal dynamic trading strategy in a closed-form explicit solution from a nonlinear Hamilton–Jacobi–Bellman partial differential equation. This analytical tractability enables us to prove rigorously that cointegration ensures the existence of statistical arbitrage using a dynamic time-consistent mean-variance strategy via asymptotic analysis. This provides the theoretical grounds for the market belief in cointegrated pairs trading. Comparison between time-consistent and precommitment trading strategies for cointegrated assets shows the former to be a persistent approach, whereas the latter makes it possible to generate infinite leverage once a cointegrating factor of the assets has a high mean reversion rate. Copyright © 2015 Elsevier B.V.
Original languageEnglish
Pages (from-to)516-534
JournalJournal of Computational and Applied Mathematics
Volume290
Early online dateJun 2015
DOIs
Publication statusPublished - 2015

Citation

Chiu, M. C., & Wong, H. Y. (2015). Dynamic cointegrated pairs trading: Mean-variance time-consistent strategies. Journal of Computational and Applied Mathematics, 290, 516-534.

Keywords

  • Cointegration
  • Mean-Variance portfolio theory
  • Pair trade
  • Time-consistency

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