Dynamic Pairs Trading Using the Stochastic Control Approach

Abstract:     
We propose a model for analyzing dynamic pairs trading strategies using the stochastic control approach. The model is explored in an optimal portfolio setting, where the portfolio consists of a bank account and two co-integrated stocks and the objective is to maximize for a fixed time horizon, the expected terminal utility of wealth. For the exponential utility function, we reduce the problem to a linear parabolic Partial Differential Equation which can be solved in closed form. In particular, we exhibit the optimal positions in the two stocks.

Number of Pages in PDF File: 20

Keywords: Optimal Stochastic Control, Pairs trading, Co-integration, Hamilton-Jacobi-Bellman equation

JEL Classification: C61

Accepted Paper Series