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Pairs Trading with Opportunity Cost

Part of: Mathematical finance Stochastic processes

Published online by Cambridge University Press:  30 January 2018

Carl Lindberg
Carl Lindberg*
Affiliation:
The Second Swedish National Pension Fund
*
∗ Postal address: The Second Swedish National Pension Fund, Box 11155, Gothenburg, 404 24, Sweden, Email address: carl.lindberg@ap2.se
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Abstract

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Pairs trading is a trading strategy which is used very frequently in the financial industry. An investment opportunity arises when the spread between two assets, which historically have exhibited autoregressive behavior, deviates from its recent history. In this case, the investor takes a long position in the asset which is expected to outperform going forward and finances this by taking a short position in the other one. If the spread converges, the investor can close both positions to generate a profit. We model the spread between two assets as an Ornstein-Uhlenbeck process and assume a constant opportunity cost. We then study the optimal liquidation strategy for an investor who wants to optimize profit in excess of the opportunity cost. Including this cost is important from an applied perspective, as the performance of any investment is always evaluated relative to the performance of the opportunity set.

Keywords

Optimal stoppingpairs tradingopportunity costoptimizationtrading

MSC classification

Primary: 91G80: Financial applications of other theories (stochastic control, calculus of variations, PDE, SPDE, dynamical systems) 60G40: Stopping times; optimal stopping problems; gambling theory
Type
Research Article
Information
Journal of Applied Probability , Volume 51 , Issue 1 , March 2014 , pp. 282 - 286
Copyright
© Applied Probability Trust 

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