Mean-variance portfolio selection of cointegrated assets
This paper considers the continuous-time mean-variance portfolio selection problem in a financial market in which asset prices are cointegrated. The asset price dynamics are then postulated as the diffusion limit of the corresponding discrete-time error-correction model of cointegrated time series. The problem is completely solved in the sense that solutions of the continuous-time portfolio policy and the efficient frontier are obtained as explicit and closed-form formulas. The analytical results are applied to pairs trading using cointegration techniques. Numerical examples show that identifying a cointegrated pair with a high mean-reversion rate can generate significant statistical arbitrage profits once the current state of the economy sufficiently departs from the long-term equilibrium. We propose an index to simultaneously measure the departure level of a cointegrated pair from equilibrium and the mean-reversion speed based on the mean-variance paradigm. An empirical example is given to illustrate the use of the theory in practice.
Year of publication: |
2011
|
---|---|
Authors: | Chiu, Mei Choi ; Wong, Hoi Ying |
Published in: |
Journal of Economic Dynamics and Control. - Elsevier, ISSN 0165-1889. - Vol. 35.2011, 8, p. 1369-1385
|
Publisher: |
Elsevier |
Keywords: | Cointegration Mean-variance portfolio theory Pairs trade |
Saved in:
Online Resource
Saved in favorites
Similar items by person
-
Mean–variance asset–liability management with asset correlation risk and insurance liabilities
Chiu, Mei Choi, (2014)
-
Mean–variance asset–liability management: Cointegrated assets and insurance liability
Chiu, Mei Choi, (2012)
-
Optimal investment for an insurer with cointegrated assets: CRRA utility
Chiu, Mei Choi, (2013)
- More ...