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Model Predictive Control for Optimal Pairs Trading Portfolio with Gross Exposure and Transaction Cost Constraints

Yuji Yamada 1 - Personal Name
James A. Primbs 2 - Personal Name

Model predictive control (MPC) is a flexible yet tractable technique in control engineering that recently has gained much attention in the area of finance, par-ticularly for its application to portfolio optimization. In this paper, we extend the MPC
with linear feedback setting in Yamada and Primbs (in: Proceedings of the IEEE con-ference on decision and control, pp 5705–5710, 2012) by incorporating the following two important and practical issues: The first issue is gross exposure (GE), which is the total value of long and short positions invested in risky assets (or stocks) as a proportion of the wealth possessed by a hedge fund. This quantity measures the leverage of a hedge fund, and the fund manager may limit the amount of leverage by imposing an upper bound, i.e., a GE constraint. The second issue is related to transaction costs, where the MPC algorithm may require frequent trades of many stocks leading to large transac- tion costs in practice. Here we assume that the transaction cost is proportional to the change in the amount of money (i.e., the change of absolute values of long or short posi-tions) invested in each stock. We formulate the MPC strategy based on a conditional
mean-variance problem which we show reduces to a convex quadratic problem, even with gross exposure and proportional transaction cost constraints. Based on numerical experiments using Japanese stock data, we demonstrate that the incorporation of the transaction cost constraint improves the empirical performance of the wealth in terms of Sharpe ratio, which may be improved further by adding the GE constraint.

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Pairs trading portfolio
Cointegration
Model predictive control
Conditional mean-variance optimization
Empirical simulations

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NPP. 3509212D1000001

Model Predictive Control for Optimal Pairs Trading Portfolio with Gross Exposure and Transaction Cost Constraints

Yuji Yamada 1 - Personal NameJames A. Primbs 2 - Personal Name

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Yuji Yamada 1 - Personal Name
James A. Primbs 2 - Personal Name