20 Pages Posted: 9 Mar 2012 Last revised: 7 Feb 2014
Date Written: March 1, 2012
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.
Keywords: Optimal Stochastic Control, Pairs trading, Co-integration, Hamilton-Jacobi-Bellman equation
JEL Classification: C61
Suggested Citation: Suggested Citation
Tourin, Agnes and Yan, Raphael, Dynamic Pairs Trading Using the Stochastic Control Approach (March 1, 2012). Journal of Economic Dynamics and Control, 2013. Available at SSRN: https://ssrn.com/abstract=2014271 or http://dx.doi.org/10.2139/ssrn.2014271
By Kangwhee Kim