Algorithmic Trading of Co-Integrated Assets
17 Pages Posted: 1 Aug 2015 Last revised: 24 May 2016
Date Written: August 19, 2015
We assume that the drift in the returns of asset prices consists of an idiosyncratic component and a common component given by a co-integration factor. We analyze the optimal investment strategy for an agent who maximizes expected utility of wealth by dynamically trading in these assets. The optimal solution is constructed explicitly in closed-form and is shown to be affine in the co-integration factor. We calibrate the model to three assets traded on the Nasdaq exchange (Google, Facebook, and Amazon) and employ simulations to showcase the strategy's performance.
Keywords: Pairs trading, algorithmic trading, high-frequency trading, co-integration, short-term alpha, stochastic control
JEL Classification: C61, C32, G11, G12
Suggested Citation: Suggested Citation