Optimal Switching for Pairs Trading Rule: A Viscosity Solutions Approach
26 Pages Posted: 24 Dec 2014
Date Written: December 23, 2014
This paper studies the problem of determining the optimal cut-off for pairs trading rules. We consider two correlated assets whose spread is modeled by a mean-reverting process with stochastic volatility, and the optimal pair trading rule is formulated as an optimal switching problem between three regimes: flat position (no holding stocks), long one short the other and short one long the other. A fixed commission cost is charged with each transaction. We use a viscosity solutions approach to prove the existence and the explicit characterization of cut-off points via the resolution of quasi-algebraic equations. We illustrate our results by numerical simulations.
Keywords: pairs trading, optimal switching, mean-reverting process, viscosity solutions
JEL Classification: C61, G11
Suggested Citation: Suggested Citation