Optimal Pairs Trading with Time-Varying Volatility

TL;DR

This paper develops a pairs trading model that accounts for time-varying volatility using stochastic control, optimizing trading strategies for co-integrated assets to maximize expected utility, with empirical tests on historical data.

Contribution

It introduces a novel pairs trading framework incorporating time-varying volatility and applies stochastic control techniques for strategy optimization.

Findings

Optimal trading strategies derived using finite difference methods.

Model effectively captures volatility dynamics in pairs trading.

Empirical results demonstrate improved performance on historical data.

Abstract

We propose a pairs trading model that incorporates a time-varying volatility of the Constant Elasticity of Variance type. Our approach is based on stochastic control techniques; given a fixed time horizon and a portfolio of two co-integrated assets, we define the trading strategies as the portfolio weights maximizing the expected power utility from terminal wealth. We compute the optimal pairs strategies by using a Finite Difference method. Finally, we illustrate our results by conducting tests on historical market data at daily frequency. The parameters are estimated by the Generalized Method of Moments.