Optimal closing of a pair trade with a model containing jumps

Stig Larsson; Carl Lindberg; Marcus Warfheimer

Applications of Mathematics (2013)

  • Volume: 58, Issue: 3, page 249-268
  • ISSN: 0862-7940

Abstract

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A pair trade is a portfolio consisting of a long position in one asset and a short position in another, and it is a widely used investment strategy in the financial industry. Recently, Ekström, Lindberg, and Tysk studied the problem of optimally closing a pair trading strategy when the difference of the two assets is modelled by an Ornstein-Uhlenbeck process. In the present work the model is generalized to also include jumps. More precisely, we assume that the difference between the assets is an Ornstein-Uhlenbeck type process, driven by a Lévy process of finite activity. We prove a necessary condition for optimality (a so-called verification theorem), which takes the form of a free boundary problem for an integro-differential equation. We analyze a finite element method for this problem and prove rigorous error estimates, which are used to draw conclusions from numerical simulations. In particular, we present strong evidence for the existence and uniqueness of an optimal solution.

How to cite

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Larsson, Stig, Lindberg, Carl, and Warfheimer, Marcus. "Optimal closing of a pair trade with a model containing jumps." Applications of Mathematics 58.3 (2013): 249-268. <http://eudml.org/doc/252477>.

@article{Larsson2013,
abstract = {A pair trade is a portfolio consisting of a long position in one asset and a short position in another, and it is a widely used investment strategy in the financial industry. Recently, Ekström, Lindberg, and Tysk studied the problem of optimally closing a pair trading strategy when the difference of the two assets is modelled by an Ornstein-Uhlenbeck process. In the present work the model is generalized to also include jumps. More precisely, we assume that the difference between the assets is an Ornstein-Uhlenbeck type process, driven by a Lévy process of finite activity. We prove a necessary condition for optimality (a so-called verification theorem), which takes the form of a free boundary problem for an integro-differential equation. We analyze a finite element method for this problem and prove rigorous error estimates, which are used to draw conclusions from numerical simulations. In particular, we present strong evidence for the existence and uniqueness of an optimal solution.},
author = {Larsson, Stig, Lindberg, Carl, Warfheimer, Marcus},
journal = {Applications of Mathematics},
keywords = {pairs trading; optimal stopping; Ornstein-Uhlenbeck type process; finite element method; error estimate; pairs trading; optimal stopping; Ornstein-Uhlenbeck-type process; finite element method; error estimate},
language = {eng},
number = {3},
pages = {249-268},
publisher = {Institute of Mathematics, Academy of Sciences of the Czech Republic},
title = {Optimal closing of a pair trade with a model containing jumps},
url = {http://eudml.org/doc/252477},
volume = {58},
year = {2013},
}

TY - JOUR
AU - Larsson, Stig
AU - Lindberg, Carl
AU - Warfheimer, Marcus
TI - Optimal closing of a pair trade with a model containing jumps
JO - Applications of Mathematics
PY - 2013
PB - Institute of Mathematics, Academy of Sciences of the Czech Republic
VL - 58
IS - 3
SP - 249
EP - 268
AB - A pair trade is a portfolio consisting of a long position in one asset and a short position in another, and it is a widely used investment strategy in the financial industry. Recently, Ekström, Lindberg, and Tysk studied the problem of optimally closing a pair trading strategy when the difference of the two assets is modelled by an Ornstein-Uhlenbeck process. In the present work the model is generalized to also include jumps. More precisely, we assume that the difference between the assets is an Ornstein-Uhlenbeck type process, driven by a Lévy process of finite activity. We prove a necessary condition for optimality (a so-called verification theorem), which takes the form of a free boundary problem for an integro-differential equation. We analyze a finite element method for this problem and prove rigorous error estimates, which are used to draw conclusions from numerical simulations. In particular, we present strong evidence for the existence and uniqueness of an optimal solution.
LA - eng
KW - pairs trading; optimal stopping; Ornstein-Uhlenbeck type process; finite element method; error estimate; pairs trading; optimal stopping; Ornstein-Uhlenbeck-type process; finite element method; error estimate
UR - http://eudml.org/doc/252477
ER -

References

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