1 / 10

Optimal Trading of a Mean-Reverting Process

Optimal Trading of a Mean-Reverting Process. MS&E 444, Spring 2008. Shih-Arng (Tony) Pan, Wei Wang, Chen Tze Wee, Ren Fung Yu. Introduction. X t is the spread between two correlated stocks: To maximize power utility of wealth at T, the optimal position of X t to hold is:.

lillian-underwood
Download Presentation

Optimal Trading of a Mean-Reverting Process

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Optimal Trading of a Mean-Reverting Process MS&E 444, Spring 2008 Shih-Arng (Tony) Pan, Wei Wang, Chen Tze Wee, Ren Fung Yu

  2. Introduction • Xt is the spread between two correlated stocks: • To maximize power utility of wealth at T, the optimal position of Xt to hold is:

  3. Choosing correlated stocks • Stocks were chosen from the S&P 100 index • Chose stock pairs with the highest correlation of daily returns (>0.75). • Examples: • International Paper/Weyerhauser • Merrill Lynch/Morgan Stanley • Chevron/Exxon Mobil • Baker Hughes/Schlumberger

  4. Unadjusted Adjusted

  5. Parameters • Parameters k and σ were estimated using MLE using January 2003 to December 2004 data. • The strategy was implemented after January 2005, out of sample. • Power Utility parameter: γ= -0.1 • Transaction cost: 0.15% of initial wealth (constant)

  6. Maximize Immediate Utility w/ Scaled MarginsChevron-Exxon (k=5.51, σ=6.47)

  7. Moving Window (of 1.5 years)Baker Hughes - Schlumberger

  8. Moving Window (of 1.5 years)Citigroup – Lehman Brothers

  9. Annual Return Histogram (18 pairs) Moving Window: Return = 1.0764 Volatility = 0.3428 No Moving Window: Return = 1.0418 Volatility = 0.5511

  10. Conclusion • Theoretical strategy too risky for market conditions. • Maximizing immediate utility w/ scaled margin strategy shows promise. • Moving Window parameter estimation improves returns, but not enough to beat market. • Better stock pairs, or a process with even more memory is required.

More Related