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Optimal portfolio selection in nonlinear arbitrage spreads

Alsayed, Hamad and McGroarty, Frank (2013) Optimal portfolio selection in nonlinear arbitrage spreads [in special issue: 2009 and 2010 Forecasting Financial Markets Conference] European Journal of Finance, 19, (3), pp. 206-227. (doi:10.1080/1351847X.2012.659265).

Record type: Article

Abstract

This paper analytically solves the portfolio optimization problem of an investor faced with a risky arbitrage opportunity (e.g. relative mispricing in equity pairs). Unlike the extant literature, which typically models mispricings through the Ornstein-Uhlenbeck (OU) process, we introduce a nonlinear generalization of OU which jointly captures several important risk factors inherent in arbitrage trading. While these factors are absent from the standard OU, we show that considering them yields several new insights into the behavior of rational arbitrageurs: Firstly, arbitrageurs recognizing these risk factors exhibit a diminishing propensity to exploit large mispricings. Secondly, optimal investment behavior in light of these risk factors precipitates the gradual unwinding of losing trades far sooner than is entailed in existing approaches including OU. Finally, an empirical application to daily FTSE100 pairs data shows that incorporating these risks renders our model’s risk-management capabilities superior to both OU and a simple threshold strategy popular in the literature. These observations are useful in understanding the role of arbitrageurs in enforcing price efficiency.

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More information

e-pub ahead of print date: 9 March 2012
Published date: 2013
Keywords: pairs trading, hamilton–jacobi–bellman equation, statistical arbitrage, stochastic optimal control, stability bounds
Organisations: Centre for Digital, Interactive & Data Driven Marketing

Identifiers

Local EPrints ID: 208877
URI: http://eprints.soton.ac.uk/id/eprint/208877
ISSN: 1351-847X
PURE UUID: c945f0c7-d87f-470b-8da5-d8e682a5b637

Catalogue record

Date deposited: 25 Jan 2012 11:55
Last modified: 18 Jul 2017 10:47

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Contributors

Author: Hamad Alsayed
Author: Frank McGroarty

University divisions

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