Pairs Trading of Two Assets with Uncertainty in Co-integration’s.pdfVIP

Pairs Trading of Two Assets with Uncertainty in Co-integration’s Level of Mean Reversion Sangmin Lee Andrew Papanicolaou This paper considers a stochastic control problem derived from a model for pairs trading under incomplete information. We decompose an individual asset’s drift into two parts: an industry drift plus some additional stochasticity. The extra stochasticity may be unobserved, which means the investor has only partial information . We solve the control problem under both full and partial information for utility function , and we make comparisons. We show the existence of stable solution to the associated matrix Riccati equations in both cases for , but for there remains potential for infinite value functions in finite time. Also, we quantify the expected loss in utility due to partial information, and present a numerical study to illustrate the contribution of this paper. Keywords: Pairs trading; Co-integration; Kalman filter; Partial Information; Stochastic Control. 1 Introduction We study the problem of optimal pairs trading strategy with uncertainty in the level of mean reversion. We consider two co-integrated assets: an industry bench mark with deterministic volatility and drift-rate ; a riskier asset related to a firm in the industry with deterministic volatility and drift additional stochasticity. This additional stochasticity is proportional to the level of mean reversion in the assets’ co- integration. We consider two market conditions: a market where investors observe drifts and another where investors do not observe drifts. Our motivation for considering unobserved drifts is because real-world growth rates for individual firms are not easy to observe. Wi