Title: A market approach for convergence trades
Authors: Isabel Figuerola-Ferretti - Universidad Pontificia Comillas (Spain)
Ioannis Paraskevopoulos - Bankia (Spain)
Tao Tang - Jinan University (China) [presenting]
Abstract: A VECM representation is proposed for cointegrated assets in the continuous-time framework that embeds the setup recently proposed in the literature. This model implies a simple framework to check for cointegration based on the condition that positive convergent speed ensures the stationarity of price spreads. A pair of cointegrated assets is then identified to derive a dynamically optimal pairs trading portfolio with a risk-free bond. This involves maximizing the portfolio value at terminal time without the requirement of a functional form for investors preferences. To do so, we connect the derived optimal portfolio with European-type spread options and in consequence the optimal investment policies can be modeled using the spread option's resulting delta hedging strategies. Our framework is tested empirically using pairs identified from the Dow Jones Industrial Average. We find that the proposed optimal strategy achieves a significant improvement in the Sharpe ratios and abnormal returns with respect to the previous work in the literature.