Trading Cointegrated Assets with Price Impact

TL;DR

This paper develops an optimal trading strategy for co-integrated assets considering price impacts and informational advantages, providing a closed-form solution and demonstrating improved performance over existing methods using real market data.

Contribution

It introduces a novel stochastic control framework for executing co-integrated assets accounting for price impacts and information, with a closed-form solution and empirical validation.

Findings

Including additional assets improves strategy performance.

The proposed method outperforms Almgren-Chriss by 4-4.5 basis points.

Closed-form solution simplifies implementation and analysis.

Abstract

Executing a basket of co-integrated assets is an important task facing investors. Here, we show how to do this accounting for the informational advantage gained from assets within and outside the basket, as well as for the permanent price impact of market orders (MOs) from all market participants, and the temporary impact that the agent's MOs have on prices. The execution problem is posed as an optimal stochastic control problem and we demonstrate that, under some mild conditions, the value function admits a closed-form solution, and prove a verification theorem. Furthermore, we use data of five stocks traded in the Nasdaq exchange to estimate the model parameters and use simulations to illustrate the performance of the strategy. As an example, the agent liquidates a portfolio consisting of shares in Intel Corporation (INTC) and Market Vectors Semiconductor ETF (SMH). We show that including the information provided by three additional assets, FARO Technologies (FARO), NetApp (NTAP) and Oracle Corporation (ORCL), considerably improves the strategy's performance; for the portfolio we execute, it outperforms the multi-asset version of Almgren-Chriss by approximately 4 to 4.5 basis points.