Skip to main content

LUP Student Papers

LUND UNIVERSITY LIBRARIES

Optimal Pairs Trading using Stochastic Control Approach

Galeev, Roman LU and Ho, Wang Ching (2010) TMA820 20101
Department of Business Administration
Abstract
Title: Optimal Pairs Trading using Stochastic Control Techniques -
A Critical Evaluation
Authors: HO, Wang Ching & GALEEV, Roman
Supervisors: Johannesson, Erik – Department of Automatic Control, Lund University
Larsson, Karl – Department of Economics, Lund University
Problem: As of date, quantitative trading methods are a strong growing niche of trading. More and more sophisticated models are employed to chase investment opportunities. The question is whether this is over-engineering and if it adds value to practitioners. We have found an interesting quantitative pairs trading strategy that belong to the family of relative value strategies. The studied stochastic control approach has many shortcomings. Among those is pair selection... (More)
Title: Optimal Pairs Trading using Stochastic Control Techniques -
A Critical Evaluation
Authors: HO, Wang Ching & GALEEV, Roman
Supervisors: Johannesson, Erik – Department of Automatic Control, Lund University
Larsson, Karl – Department of Economics, Lund University
Problem: As of date, quantitative trading methods are a strong growing niche of trading. More and more sophisticated models are employed to chase investment opportunities. The question is whether this is over-engineering and if it adds value to practitioners. We have found an interesting quantitative pairs trading strategy that belong to the family of relative value strategies. The studied stochastic control approach has many shortcomings. Among those is pair selection method which is not defined at all. Furthermore it has not yet been applied to real market data which makes it interesting to see how well it performs against a more basic pairs trading strategy.
Purpose: The purpose of this thesis is to define a suitable pair selection method that supports the theoretical framework of stochastic control and to test this selection strategy against a more basic pairs trading strategy on historical market data.
Method: Through communication with hedge fund officials insight was gained on how investment strategies are applied in the market. Secondary data was gathered through the Datastream database, and the different simulations were run in MATLAB. Mathematical and economical theories were gathered through various textbooks and articles, and the direction of the study was discussed and decided with the advice of the supervisors.
Conclusion: The method of stationarity through ADF test was found to be the best of the selection methods tested with the stochastic control approach. After finding proper time frames the stochastic control approach was benchmarked against a basic control strategy. The outcome shows that the specific quantitative strategy chosen for this study is flawed and therefore might not perform as well as it should with less assumptions made in the modeling. This is a sign of a possible over-engineering phenomenon that exists in the market in competition for investment opportunities.
Key words: Pairs Trading, Market Neutral Strategy, Stochastic Control, Cointegration, Stationarity, Hedge Fund Investment Strategies. (Less)
Please use this url to cite or link to this publication:
author
Galeev, Roman LU and Ho, Wang Ching
supervisor
organization
alternative title
A Critical Evaluation
course
TMA820 20101
year
type
H2 - Master's Degree (Two Years)
subject
keywords
Hedge Fund Investment Strategies., Stationarity, Market Neutral Strategy, Pairs Trading, Cointegration, Stochastic Control
ISSN
1651-0100
language
English
id
1623715
date added to LUP
2010-06-23 12:42:45
date last changed
2010-06-23 12:42:45
@misc{1623715,
  abstract     = {{Title: Optimal Pairs Trading using Stochastic Control Techniques -
A Critical Evaluation
Authors: HO, Wang Ching & GALEEV, Roman
Supervisors: Johannesson, Erik – Department of Automatic Control, Lund University
Larsson, Karl – Department of Economics, Lund University
Problem: As of date, quantitative trading methods are a strong growing niche of trading. More and more sophisticated models are employed to chase investment opportunities. The question is whether this is over-engineering and if it adds value to practitioners. We have found an interesting quantitative pairs trading strategy that belong to the family of relative value strategies. The studied stochastic control approach has many shortcomings. Among those is pair selection method which is not defined at all. Furthermore it has not yet been applied to real market data which makes it interesting to see how well it performs against a more basic pairs trading strategy.
Purpose: The purpose of this thesis is to define a suitable pair selection method that supports the theoretical framework of stochastic control and to test this selection strategy against a more basic pairs trading strategy on historical market data.
Method: Through communication with hedge fund officials insight was gained on how investment strategies are applied in the market. Secondary data was gathered through the Datastream database, and the different simulations were run in MATLAB. Mathematical and economical theories were gathered through various textbooks and articles, and the direction of the study was discussed and decided with the advice of the supervisors.
Conclusion: The method of stationarity through ADF test was found to be the best of the selection methods tested with the stochastic control approach. After finding proper time frames the stochastic control approach was benchmarked against a basic control strategy. The outcome shows that the specific quantitative strategy chosen for this study is flawed and therefore might not perform as well as it should with less assumptions made in the modeling. This is a sign of a possible over-engineering phenomenon that exists in the market in competition for investment opportunities.
Key words: Pairs Trading, Market Neutral Strategy, Stochastic Control, Cointegration, Stationarity, Hedge Fund Investment Strategies.}},
  author       = {{Galeev, Roman and Ho, Wang Ching}},
  issn         = {{1651-0100}},
  language     = {{eng}},
  note         = {{Student Paper}},
  title        = {{Optimal Pairs Trading using Stochastic Control Approach}},
  year         = {{2010}},
}