Time-Consistent Mean-Variance Pairs-Trading Under Regime-Switching Cointegration

31 Pages Posted: 11 Oct 2018

See all articles by Kexin Chen

Kexin Chen

Hong Kong Polytechnic University

Mei Choi Chiu

The Education University of Hong Kong - Department of Mathematics & Information Technology

Hoi Ying Wong

The Chinese University of Hong Kong (CUHK) - Department of Statistics

Date Written: September 16, 2018

Abstract

While cointegration models with constant parameters generate statistical arbitrage, the cointegration feature may change and even disappear due to regime shifts. This paper studies the time-consistent mean-variance portfolio problem in a Markov-modulated regime switching cointegration economy. We derive a novel closed-form solution to the equilibrium strategy. This analytical solution allows us to investigate statistical arbitrage with regime-switching pairs-trading rules. The presence of regime switching increases the risk of such trading strategies, especially near the switching times. Empirical analysis demonstrates the use of the derived formulas and shows the advantages of incorporating different market modes.

Keywords: Regime-switching, Mean-variance, Time-inconsistency

JEL Classification: C61, G11

Suggested Citation

Chen, Kexin and Chiu, Mei Choi and Wong, Hoi Ying, Time-Consistent Mean-Variance Pairs-Trading Under Regime-Switching Cointegration (September 16, 2018). Available at SSRN: https://ssrn.com/abstract=3250340 or http://dx.doi.org/10.2139/ssrn.3250340

Kexin Chen (Contact Author)

Hong Kong Polytechnic University ( email )

Hong Kong

Mei Choi Chiu

The Education University of Hong Kong - Department of Mathematics & Information Technology ( email )

Tai Po,, N.T.
Hong Kong

Hoi Ying Wong

The Chinese University of Hong Kong (CUHK) - Department of Statistics ( email )

Shatin, N.T.
Hong Kong

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