A Market approach for convergence trades

Abstract

This paper proposes a VECM representation for cointegrated assets in the continuous- time framework. This model implies a simple framework to check for cointegration exploiting the restriction that the stationarity of price spread requires positive convergent speed. A pair of cointegrated assets is then identi ed to derive a dy- namically optimal pairs trading portfolio with a risk-free bond. This involves maximizing the portfolio value at terminal time without the requirement of a func- tional form for investor´s preferences. To this end, we connect the derived optimal portfolio with European-type spread options and in consequence the optimal in- vestment policies can be modeled using the spread option's resulting delta hedging strategies. Our framework is tested empirically using pairs identi ed from the Dow Jones Industrial Average. This analysis requires maximum likelihood esti- mates on continuous VECM parameters, compared to the benchmark Johansen methodology. We nd that the proposed optimal strategy delivers consistent prof- itability and outperforms the Johansen method commonly applied in the previous literature.