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Dynamic Spread Trading

Seung-Jean Kim

James Primbs

Stephen Boyd

June 2008
Abstract
This paper is concerned with a dynamic trading strategy, which involves multiple
synthetic spreads each of which involves long positions in a basket of underlying se-
curities and short positions in another basket. We assume that the spreads can be
modeled as mean-reverting Ornstein-Uhlenbeck (OU) processes. The dynamic trading
strategy is implemented as the solution to a stochastic optimal control problem that
dynamically allocates capital over the spreads and a risk-free asset over a nite horizon
to maximize a general constant relative risk aversion (CRRA) or constant absolute risk
aversion (CARA) utility function of the terminal wealth. We show that this stochastic
control problem is computationally tractable. Specically, we show that the coecient
functions dening the optimal feedback law are the solutions of a system of ordinary
dierential equations (ODEs) that are the essence of the tractability of the stochastic
optimal control problem. We illustrate the dynamic trading strategy with four pairs
that consist of seven S&P 500 index stocks, which shows that the performance achieved
by the dynamic spread trading strategy is signicant and robust to realistic transaction
costs.
Key words: convergence trading, dynamic trading, mean reversion, pairs trading,
statistical arbitrage, stochastic optimal control.
1 Introduction
We consider an investment setting in which there are and n continuously traded risky secu-
rities, whose prices are collected in the price vector P(t) R
n
, and a risk-free asset (i.e., a
money market account paying a xed rate of interest). We are interested in the situation in
which certain linear combinations
S
i
(t) =
T
i
P(t), i = 1, . . . , m, (1)

Information Systems Laboratory, Electrical Engineering Department, Stanford University, Stanford, CA


94305-9510 USA. Email: {sjkim,boyd}@stanford.edu

Management Science and Engineering, Stanford University, Stanford, CA 94305-4026 USA. Email:
japrimbs@stanford.edu
1
with
i
R
n
, are mean reverting such that S
i
can be well modeled as OU processes. Here, S
i
can be simply the dierence between the prices of two securities, i.e., their spread. More
generally, S
i
can be a (synthetic) spread, i.e., the spread between the values of two baskets
of the underlying securities.
In the standard dynamic portfolio optimization setting, we model the prices of the under-
lying risky securities as stochastic processes (e.g., geometric Brownian motion) and formulate
the optimal investment problem as a stochastic control problem that allocates capital directly
over the risk-free and risk assets to maximize an expected utility function. In this paper,
we are interested in the stochastic optimal control problem of dynamically allocating capital
over the risk-free asset and the multiple spreads, to maximize an expected utility function of
the terminal wealth, which we call dynamic (synthetic) spread trading. (This strategy indi-
rectly determines the inventory levels of the underlying securities through the allocations on
the spreads.) Our main focus is on the optimal trading strategy and not on the estimation
of the coecient vectors
i
that specify the spreads. (The estimation part is related to
estimating cointegration vectors in vector autoregressive models and beyond the scope of
this paper. The reader is referred to Bossaerts (1988) or Johansen (1991) for more on the
estimation part.)
We show that this stochastic control problem is computationally tractable for general
CRRA and CARA utility functions. Specically, we characterize the optimal feedback law
in an ane feedback form and show that the coecient functions dening the optimal feed-
back law are the solutions of a system of ODEs that are the essence of the tractability of the
stochastic optimal control problem. Interestingly, as in the standard dynamic portfolio opti-
mization setting based on the GBM model, the optimal feedback for CRRA utility functions
is proportional to current wealth, while that for CARA utility functions is independent of
current wealth.
We illustrate the dynamic spread trading strategy for CRRA utility functions, using a
discrete-time approximation that balances the holding of the underlying securities on a daily
basis. We apply this approximation to four pairs that consist of S&P 500 index stocks. We
assume that the fraction of wealth in the money market account can be used as collateral to
nance the long/short positions in the underlying stocks, and compute the (daily) margin
requirement for a broker/dealer, who can employ higher levels of leverage than individual
investors. The results shows that, while meeting the margin requirement, the dynamic
trading strategy can deliver a good performance, which is robust to realistic transaction
costs. The results also show that the return distribution of the dynamic spread trading
strategy has a very acute peak around the mean, compared with a normally distributed
random variable, i.e., it is is leptokurtic.
Related literature. The spread trading strategy described above can be viewed as a
generalization of pairs trading, a relative investment or convergence trading strategy that
has been widely used in practice. (It reduces to pairs trading when m = 1 and the single
synthetic spread is the dierence between the prices of two securities.) Once pairs of stocks
that are cointegrated are identied, we can easily turn them into a relative investment
2
trading strategy: When the spread between their prices deviates signicantly from the long-
term average, this strategy is to short one security and buy the other, expecting prot
when the spread converges. (The reader is referred to Vidyamurthy (2004) and Whistler
(2004) for more on this strategy.) Gatev et al. (2006) demonstrate the eectiveness and
robustness of pairs trading based on a simple thresholding rule, while taking into account
microstructure factors such as the bid-ask bounce, shortselling costs, and transaction costs.
Mudchanatongsuk et al. (2008) derive the optimal feedback control law when the spread of
the log-prices of two stocks follows an OU process. Mitchell et al. (2002) study limits of
arbitrage in the context of pairs trading, using a simple thresholding investment decision
rule. Boguslavsky and Boguslavskaya (2004) and Jurek and Yang (2007) derive the optimal
trading strategy for pairs trading. Elliott et al. (2005) propose a mean-reverting Gaussian
Markov chain model for the spread observed in Gaussian noise which is used to determine
appropriate investment decisions. The prior work does not take into account correlations
among spreads and deals with only one spread.
The techniques used in this paper to characterize the solution of the stochastic optimal
control problem with multiple spreads are quite standard: Guess a parametric form of the
value function, i.e., the solution to the HJB equation that encodes the optimal feedback
law and derive a system of ODEs for the functions involved in the parametrization. Using
these standard techniques, several researchers have solved a variety of dynamic portfolio
selection problems (some of which involve OU processes). Kim and Omberg (1996) derive
an analytical solution to the portfolio selection problem with a hyperbolic absolute risk
aversion (HARA) utility function utility of the terminal wealth when the risk premium
is governed by an Ornstein-Uhlenbeck process. Herzog et al. (2008) describes an analytical
solution to a dynamic portfolio optimization selection problem with a CRRA utility function
in which risky assets are modeled with a factor model based on Gaussian stochastic processes,
which are used to model the assets time-varying expected returns. Schroder and Skiadas
(1999) examine conditions under which dynamic portfolio choice problems reduce to solving
a system of ordinary dierential equations. Campbell et al. (2004) derive an approximate
solution to a continuous-time intertemporal portfolio and consumption choice problem, in a
setting in which the expected excess return on a risky asset follows an OU process, while the
riskless interest rate is constant; the reader is also referred to Campbell and Viceira (2002).
Outline. In the next section, we give the continuous time formulation of the dynamic
spread trading problem. In Section 3, we characterize the optimal spread trading strategy
for the CRRA and CARA utility functions. In Section 4, we illustrate the dynamic trading
strategy with four spreads, while accounting for realistic transaction costs. We give our
conclusions in Section 5.
3
2 Problem formulation
2.1 The model
The risk-free asset grows at a constant, continuously compounded rate of r > 0:
dB(t) = rB(t)dt.
The m spreads are modeled by a vector process S = (S
1
, . . . , S
m
), where the component S
i
is modeled as an Ornstein-Uhlenbeck process (Uhlenbeck and Ornstein 1930)
dS
i
(t) =
i
(

S
i
S
i
(t))dt +
m

i=1

ij
dZ
j
(t),
where Z
1
, . . . , Z
m
are independent Wiener processes,

S
i
is the long-term mean of the spread
S
i
, and
i
> 0 is the rate of reversion. We can write the spread dynamics in the compact
form
dS(t) = K(

S S(t))dt +dZ(t) (2)


where Z = (Z
1
, . . . , Z
m
) is an m-dimensional vector Wiener process,
=
_

11

1m
.
.
.
.
.
.
.
.
.

m1

mm
.
_

_
is the diusion matrix, and K = diag(
1
, . . . ,
m
) is the diagonal matrix with diagonal
entries
i
.
We consider a self-nancing portfolio (with no exogenous infusion of withdrawal of money)
that consists of the m spreads and the risk-free asset. We use h
i
(t) to denote the number of
units of spread i held at time t and dene h(t) = (h
1
(t), . . . , h
m
(t)). We use W(t) to denote
the value of the portfolio held at t or the wealth. We can see that h(t)
T
S(t) is the total value
of the positions in the spreads (or their underlying securities) and W(t) h(t)
T
S(t) is the
dollar amount put in the risk-free asset. The wealth of the self-nancing portfolio evolves
according to
dW(t) = h(t)
T
dS(t) + [W(t) h(t)
T
S(t)]rdt
=
_
r(W(t) h(t)
T
S(t)) +h(t)
T
K(

S S(t))

dt +h(t)
T
dZ(t).
2.2 The problem
We assume that there are no transaction costs (short selling costs, bid-ask spreads, price
impact, and so on). (Later we will include the eects of market frictions in assessing the
performance of the dynamic spread trading strategy we will describe shortly.)
4
We consider the problem of nding a dynamic trading strategy that maximizes expected
utility at the nal time T, E[u(W(T))], which can be cast as the following stochastic optimal
control problem:
maximize E[U(W(T))]
subject to dS(t) = K(

S S(t))dt +dZ(t),
dW(t) =
_
r(W(t) h(t)
T
S(t)) +h(t)
T
K(

S S(t))

dt +h(t)
T
dZ(t),
S(0) = (S
1
(0), . . . , S
m
(0)), W(0) = W
0
,
(3)
where the variable is the stochastic process h adapted to the ltration F(t) associated with
the Wiener processes under consideration and the problem data are K, , and

S. In this
optimal control problem, the rst and second constraints describe the spread and wealth
dynamics respectively, and the last constraints specify the initial wealth of our portfolio and
spreads. Under suitable conditions on trading strategies, the existence and uniqueness of
solution follow from standard results in stochastic control theory.
3 Dynamic trading with multiple spreads
In this section, we will derive the optimal trading strategies for two families of utility func-
tions, one that consists of CRRA utility functions and the other that consists of CARA
utility functions. Our focus will be on the derivation of the optimal feedback law, using the
standard technique based on the corresponding HJB equation, and not on the technical con-
ditions for the existence and uniqueness of the optimal one. The existence and uniqueness
can be established rigorously, using the verication theorem for stochastic optimal control
(Bjork 2004). The proof is based on standard arguments and so omitted.
3.1 The HJB equation
We start by dening the value function V as
V (t, W, S) = sup
h
E
_
U(W(T))

S(t) = S, W(t) = W
_
,
where the supremum is taken over all F(t)-adapted stochastic processes. Here by abuse of
notation, we denote the wealth and spreads at time t as W and S, respectively. We assume
that the value function is suciently regular so that the gradient and Hessian of the value
function V evaluated at (t, W, S) exists:
g =
_
_
V
t
V
W
V
S
_
_
R
m+2
, H =
_
_
V
tt
V
tW
V
tS
V
Wt
V
WW
V
WS
V
St
V
SW
V
SS
_
_
R
(m+2)(m+2)
.
Here we omit the arguments and we denote the derivative of f with respect to x as f
x
.
5
Under suitable technical conditions, the value function V solves the Hamilton-Jacobi-
Bellman (HJB) equation
V
t
+ sup
h
_
V
W
(r(W h
T
S) +h
T
K(

S S)) +V
T
S
K(

S S)
+
1
2
V
WW
h
T
h +
1
2
Tr(
T
V
SS
) +h
T
V
SW
_
= 0
with the nal condition
V (T, W, S) =
W
1
1
.
Here,
=
T
R
mm
.
(The reader is referred to ksendal (1998) for the details.) The rst-order condition for the
supremum is
h =
1
V
WW

1
_
V
W
(K(

S S) rS) + V
SW

.
The HJB equation becomes
V
t
+V
W
rW +V
T
S
K(

S S) +
1
2
Tr(
T
V
SS
) f(S, W) = 0, (4)
where
f(S, W) =
1
2V
WW
_
V
W
(K(

S S) rS) + V
SW

1
_
V
W
(K(

S S) rS) + V
SW

.
3.2 Dynamic trading with CRRA utility functions
We rst consider the HJB (4) with CRRA utility functions. A CRRA utility function has
the form
U(W) =
_
_
_
W(T)
1
1
, = 1, > 0,
log W, = 1,
where > 0 is the relative risk aversion parameter.
The value function we guess has the form
V (t, W, S) =
_
_
_
W
1
1
exp(S
T
A(t)S +b(t)
T
S +c(t)), = 1, > 0,
log W +S
T
A(t)S +b(t)
T
S +c(t), = 1.
(5)
with the functions A : [0, T] R
mm
, b : [0, T] R
m
, and c : [0, T] R. The functions
satisfy the nal conditions
A(T) = 0 R
mm
, b(T) = 0 R
m
, c(T) = 0 R.
6
If the value function is indeed of this form, then the optimal feedback law is
h(t) =
_
_
_
W(t)

1
K(

S S(t)) rS(t) + 2A(t)S(t) +b(t)

, = 1, > 0,
W(t)
1
_
K(

S S(t)) rS(t)

, = 1.
(6)
Here, the three functions A, b, and c can be found via solving a system of ODEs, as will
be derived shortly. In the logarithmic case, the optimal feedback law is time-invariant and
depends only on the current wealth and spreads.
The special case of logarithmic utility ( = 1)
In the logarithmic utility case, the optimal feedback law does not depend on the functions
A, b, and c. In this case, the functions A, b, and c satisfy the ODEs

A(t) = A(t)
T
K +K
T
A(t)
1
2
(K +rI)
T

1
(K +rI) , (7)

b(t) = 2A(t)
T
K

S +K
T
b(t) r
1
K

S, (8)
c(t) = r b(t)
T
K

S Tr(A(t))
1
2

S
T
K
T

1
K

S. (9)
The derivation is deferred to the appendix. These equations are linear, so we can readily
nd their analytic solutions. We omit the details.
The general case of = 1
We now turn to the case when = 1. The matrix-valued function A solves a matrix Riccati
dierential equation of the form

A(t) +A(t)
T
XA(t) A(t)
T
Y Y
T
A(t) Q = 0, (10)
with
X =
2

, Y =
1

(K r( 1)I), Q = (K +rI)
T

1
(K +rI) ,
and
=
(1 )
2
2(
2
)
=
1
2
.
The functions b and c solve the ODEs

b(t) + 2A(t)
T
K

S + [2A(t)
T
K
T
]b(t) 2 [2A(t) K rI]
T

1
[K

S + b(t)] = 0 (11)
and
c(t) + +b(t)
T
K

S +
1
2
b(t)
T
b(t) +Tr(A(t)) (b(t) +K

S)
T

1
(b(t) +K

S) = 0,(12)
7
with = (1 )r. The derivation is deferred to the appendix.
Unlike the special case of logarithmic utility, we cannot solve these ODEs analytically.
This system of ODEs has an interesting property: Once A is computed numerically, we
can analytically solve the other two ODEs, since they are linear. The Riccati dierential
equation (10) can be solved eciently; there has been an extensive amount of work on
numerical methods for solving matrix Riccati dierential equations (see, e.g., Kenney and
Leipnik (1985) and Martn-Herran (1999)).
Decomposition
The dynamic optimal trading law (6) can be decomposed as
h(t) = h
myopic
(t) +h
temp
(t),
where
h
myopic
(t) =
W(t)

1
K(

S S(t)) rS(t)

is the myopic component which is independent of the time horizon considered and
h
temp
(t) =
W(t)

[2A(t)S(t) +b(t)]
is the intertemporal component that depends on the time horizon (and other problem data).
The intertemporal component hedges against or speculates on the mean-reverting charac-
teristics of the spreads. As t approaches the terminal time T, the intertemporal component
vanishes. (Jurek and Yang (2007) give an extensive discussion on the economic interpretation
of each component for the single spread case.)
Dynamic spread trading and inventory control
In terms of the inventory levels I(t) R
n
of the underlying n risky assets, the optimal
feedback law can be implemented as
I(t) = h(t)
where = [
1

m
] R
nm
is the matrix whose columns are the coecient vectors that
specify the mean-reverting relations in (1). The ith entry, I
i
(t), of I(t) species the number
of shares of asset i in the inventory at time t with a long position in asset i corresponding
to I
i
(t) > 0, and a short position in asset i corresponding to I
i
(t) < 0.
The dynamic spread trading strategy is a long/short strategy that dynamically changes
the inventory levels to exploit the mean-revering characteristics of the linear combinations
of the underlying securities specied in (1). It is not necessarily market neutral or dollar
neutral in a strict sense, but we can choose the coecient vectors
i
that specify the spreads
to limit market and sector exposures.
8
3.3 Dynamic trading with CARA utility functions
We turn to dynamic spread trading with a general CARA utility function. A CARA utility
function has the form
u(W) =
1

e
W
, (13)
where the parameter > 0 describes the risk aversion of the investor. In the same spirit as
before, we can also solve the HJB equation (4) with a general CARA utility function u.
The value function we postulate has the form
V (t, W, S) =
1

e
S(t)
T
A(t)S(t)+b(t)
T
S(t)+c(t)W(t)+d(t)
, (14)
where A : [0, T] R
mm
, b : [0, T] R
m
, and c, d : [0, T] R. The next step is to derive
the ODEs for the functions A, b, c, and d which ensure that this value function solves the
HJB equation (4) with the terminal condition
V (T, W, S) =
1

e
W
.
In view of the terminal condition, these functions should satisfy the nal conditions
A(T) = 0 R
mm
, b(T) = 0 R
m
, c(T) = R, d(T) = 0 R.
We can derive the ODEs for the functions A, b, c, and d. The ODE for A is a matrix
Riccati dierential equation of the form

A(t) A(t)
T
K k
T
A(t)
1
2
[2A(t) K rI]
T

1
[2A(t) K rI] = 0. (15)
The function b, c, and d solve the ODEs

b(t) Kb(t) +2A(t)


T
K

S + 2A(t)
T
b(t) (2A(t) K rI)
T

1
(K

S + b(t)) = 0, (16)
c(t) +rc(t) = 0, (17)
and

d(t) =
_
b(t)
T
K

S +
1
2
b(t)
T
b(t)
1
2
[K

S + b(t)]
T

1
[K

S + b(t)]
_
, (18)
respectively. The derivation is deferred to the appendix.
We can analytically solve the ODE for c to obtain
c(t) = e
(tT)
.
Once the matrix Riccati dierential equation for the matrix-valued function A is numerically
solved, the linear ODE for b can be solved easily. It is then straightforward to compute d
from b by integrating both sides of (18). These ODEs have unique solutions, so the value
9
function (14) indeed solves the HJB equation (4). Then, it is straightforward to show that
the feedback law dened in (6) is optimal for the stochastic optimal control problem with
the CARA utility function (13).
The optimal feedback law can be written as
h(t) =
1
e
(tT)

1
_
(K(

S S) rS(t)) + [2A(t)S(t) +b(t)]

.
The optimal trading law is very similar to that for the CRRA utility function case; one
signicant dierence is that unlike that for the CRRA utility function case, it is independent
of current wealth, which is a well-known property of CARA utility functions.
4 Experimental results
To illustrate the dynamic trading strategy described above, we apply it to four pairs that
consist of several S&P 500 index stocks. In the set of empirical results shown below, the
estimation and trading tasks are completely separated, meaning that once the model pa-
rameters are estimated with a data set over an estimation period they are xed throughout
the trading period and no online parameter update is done. Although online update often
leads to an improved performance, we report here the results that illustrate most closely the
dynamic trading strategy.
4.1 The setup
The dynamic trading strategy specied by solving a stochastic control problem is theoretical
and cannot be implemented in the original form; in real trading, we cannot trade continu-
ously. In our experimental study, we use a discrete-time approximation of the continuous
trading strategy specied by solving a stochastic control problem. We adjusted the portfolio
(of the risk-free asset and spreads) daily. (We point out that it is possible to implement
a discrete-time approximation on a shorter or longer time scale.) Transaction costs are
explicitly accounted for, while shortselling costs are not.
The assets and pairs
The underlying securities considered in our experimental are given in Table 1. (These stocks
constitute S&P 500 index stocks, and so are highly liquid.) The risk-free return is taken as
r = 4% per annum.
The securities are paired as shown in Table 2, to construct the spreads. Out of the four
pairs, HD/LOW and F/GM are widely known among practitioners of pairs trading. The
other two need some explanation. PBG is the worlds largest bottler of Pepsi-Cola beverages
and has the exclusive right to manufacture, sell and distribute Pepsi-Cola beverages in many
states of the USA and many other countries. It is therefore natural to expect that the
prices of PEP and PBG tend to move together. Masco Corporation is in the manufacturing
10
index company ticker symbol
1 Home Depot HD
2 Lowes Companies, Inc. LOW
3 PepsiCo, Inc. PEP
4 Pepsi Bottling Group, Inc. PBG
5 Ford Motor Company F
6 General Motors Corporation GM
7 Masco Corporation MAS
Table 1: Stocks used in our numerical study.
pair ticker symbols of constituent stocks estimated cointegrating vector
1 HD and LOW (1, 1.2655)
2 PEP and PBG (1, 1.8264)
3 F and GM (1, 0.3362)
4 HD and MAS (1, 1.3056)
Table 2: Pairs and estimated cointegrating relations.
and distribution of branded consumer products for homes and families, and Home Depot
accounts for a large portion of its sales (more than a quarter). For the same reason, it is not
surprising that the stock prices of HD and MAS tend to move together. Since HD appears
in both pair 1 and pair 4, their spreads (the dierences between appropriately scaled prices
whose proportions are to be estimated from historical data) are highly correlated.
The whole period considered in our numerical study is from the rst trading date in June
2002 to the last trading data in May 2008. (The whole horizon consists of 1444 trading
days.) We use the early four-year data (from June 2002 through May 2006, called the
estimation period), to estimate the model parameters in the trading algorithm and then use
the remaining data set (from June 2006 through May 2008, called the trading period) to
validate the dynamic trading algorithm. From now on, t = 1 corresponds to the start date of
the estimation period and t = N
estim
corresponds to the last date of the estimation period.
The total number of trading days is N
trading
, so the trading period is from t = N
estim
+ 1
to t = N
estim
+ N
trading
. For the moment, we x the horizon sizes to N
trading
= 4 251 and
N
trading
= 2 251. (Later we will change the sizes, to examine their eects on the performance
of the dynamic trading strategy.)
We used adjusted close prices, namely, the closing prices day adjusted for all applica-
ble splits and dividend distributions, which were downloaded from Yahoo nance (http:
//finance.yahoo.com/). (The data are adjusted using appropriate split and dividend mul-
tipliers, in accordance with Center for Research in Security Prices (CRSP) standard.) We
use P
ABC
(t) to denote the close price of the stock whose ticker symbol is ABC. We assume
that the dynamic spread trading strategy purchases or sells the stocks at the adjusted close
prices.
11
Figure 1 shows time plots of adjusted close prices of the stocks grouped together according
to the pairing described above for the period of June 2002 to May 2008. It is obvious from
the plots that the constituent stocks of each pair tend to move together.
Spread construction
To construct spreads from the four pairs, we need to determine how many shares of the
second constituent stock are to be sold, while buying one share of the rst one. To do so,
we regressed the price of the rst constituent stock onto that of the other one with the price
data over a period. For instance, the ratio
HD/LOW
for the HD/LOW pair minimizes the
root mean square (RMS) error
N
estim

t=1
(P
HD
(t) P
LOW
(t))
2
.
(This ordinary least squares (OLS) method is described in Engle and Granger (1987) in the
context of cointegrating vector estimation.) The estimate ratios found via the OLS with
N
estim
= 4 251 are

HD/LOW
= 1.2655,

PEP/PBG
= 1.8264,

F/GM
= 0.3302,

HD/MAS
= 1.3056.
For instance, the rst cointegrating relation means that we need to sell 1.2655 shares of LOW,
while buying one share of HD, to minimize the RMS error (over the estimation period).
The corresponding four spreads are
S
1
(t) = P
HD
(t)
HD/LOW
P
LOW
(t),
S
2
(t) = P
PEP
(t)
PEP/PBG
P
PBG
(t)
S
3
(t) = P
F
(t)
F/GM
P
GM
(t)
S
4
(t) = P
HD
(t)
HD/MAS
P
MAS
(t).
Figure 2 shows the time plots of the spreads over the whole period including the trading
period. The cointegrating relations do not appear to break down over the trading period.
Model calibration
We calibrated a mean-reverting model to the spreads observed over the four-year estimation
period. For calibration purposes, we derive the discrete-time vector autoregressive (VAR)
representation of the vector OU process (2):
S(t + 1) = (I tK(

S S(t)) +

tZ(t),
12
where t = 1/251 .
For the estimation of parameters in the VAR model given above, we used ARt, a Mat-
lab package for the estimation of parameters and eigenmodes of multivariate autoregressive
models (Neumaier and Schneider 2001a,b). The estimated model parameters using the data
set over the estimation period are

S =
_

_
0.0964
0.1111
0.0162
0.2653
_

_
R
4
,

K =
_

_
4.5710 0 0 0
0 3.5519 0 0
0 0 2.3895 0
0 0 0 5.2002
_

_
R
44
,
and

=
_

_
48.6848 2.2723 0.2250 24.1554
128.7793 0.2836 0.8678
8.4051 0.0948
68.4779
_

_
R
44
.
(Only the upper triangular part is shown because the matrix is symmetric.) We can see that
the rst and last spreads are highly correlated (since HD is common in both pairs). The
spreads of the other two pairs PEP/PBG and F/GM tend to move independently of each
other and of these correlated pairs (HD/LOW and HD/MAS). We point out that it is possible
to recover a maximum likelihood estimate (MLE) of the parameters in the continuous-time
model from discretely sampled data points, since OU processes are Gaussian; see, e.g.,
Bergstrom (1984). But we found that the MLE was rather unstable.
13
ts
year year
year year
p
r
i
c
e
[
$
]
p
r
i
c
e
[
$
]
p
r
i
c
e
[
$
]
p
r
i
c
e
[
$
]
1/03 1/03
1/03 1/03
1/04 1/04
1/04 1/04
1/05 1/05
1/05 1/05
1/06 1/06
1/06 1/06
1/07 1/07
1/07 1/07
1/08 1/08
1/08 1/08
0
10
20
30
40
50
0
20
40
60
80
100
0
10
20
30
40
50
0
10
20
30
40
50
Figure 1: Time plots of stock prices for the period of June 2002 to May 2008. Top
left: P
HD
(t) (solid) and P
LOW
(t) (dashed). Top right: P
PEP
(t) (solid) and P
PBG
(t)
(dashed). Bottom left: P
F
(t) (solid) and P
GM
(t) (dashed). Bottom right: P
HD
(t)
(solid) and P
MAS
(t) (dashed). The vertical dotted line divides the whole period into
estimation period (June 2002 to May 2006) and trading period (June 2006 to May
2008).
14
year year
year year
s
p
r
e
a
d
[
$
]
s
p
r
e
a
d
[
$
]
s
p
r
e
a
d
[
$
]
s
p
r
e
a
d
[
$
]
1/03 1/03
1/03 1/03
1/04 1/04
1/04 1/04
1/05 1/05
1/05 1/05
1/06 1/06
1/06 1/06
1/07 1/07
1/07 1/07
1/08 1/08
1/08 1/08
-15
-10
-5
0
5
10
15
-6 -6
-6
-4 -4
-4
-2 -2
-2
0 0
0
2 2
2
4 4
4
6 6
6
Figure 2: Time plots of four spreads for the period of June 2003 to May 2008.
Top left: P
HD
(t) 1.266P
LOW
(t). Top right: P
F
(t) 1.826P
GM
(t). Bottom left:
P
PEP
(t) 0.330P
PBG
(t). Bottom right: P
HD
(t) 1.306P
MAS
(t). The coecients are
estimated from price data over the estimation period from June 2002 through May
2006.
15
4.2 Performance assessment
We consider a scenario in which the investor with a CRRA utility function applies the
dynamic spread trading strategy to the four spreads in Table 2 with ten million dollar initial
capital and wants to withdraw his investment after T years. Using the solution method
described above, we compute the functions A, b, and c that specify the optimal feedback
control law with T years, via solving the ODEs (10) and (11) with the problem data given
above. We set the investment horizon as T = 2 (years), which is the same as the trading
horizon size. (Later we will show how its choice aects the overall performance of the dynamic
spread trading strategy.)
We describe the optimal feedback law in terms of the daily close prices of the 7 underlying
stocks:
h(t) =
W(t)

1
K
_

S
T
P(t)
_
rS(t) + 2A(t)
T
P(t) +b(t)
_
R
4
,
where

T
=
_

_
1
HD/LOW
0 0 0 0 0
0 0 1
PEP/PBG
0 0 0
0 0 0 0 1
F/GM
0
1 0 0 0 0 0
HD/MAS
_

_
describes the four estimated cointegrating relations among the stocks described above. This
feedback control law controls the inventory levels of the 7 underlying stocks as
I(t) = h(t) R
7
.
The ith entry, I
i
(t), of I(t) species the inventory level of asset i. We assume that the initial
inventory levels of the stocks are zero, meaning that the initial capital is put into the money
market account.
Performance metrics
We will compare the following four quantities: annualized risk and return (over the trad-
ing period), annualized Sharpe ratio (SR) relative to the 4% risk-free rate, and maximum
drawdown (MD). The maximum drawdown at time t is the largest drawdown of the wealth
experienced by the trading strategy up to time t:
MDD(t) =
W(t)
sup
st
W(s)
.
The maximum drawdown is the maximum cumulative loss from a peak to the following
trough:
MD = sup
t=N
estim
,...,N
trading
MDD(t).
16
Eects of transaction costs on the performance
Several researchers have demonstrated that pairs trading could outperform signicantly
benchmark indexes without taking into account transaction costs. An obvious question to
ask is whether the strategy would continue to outperform the indices (or even yield positive
returns) when realistic transaction costs are accounted for.
The change of the inventory level of stock i from time t to the next trading day incurs
purchasing or selling |I
i
(t + 1) I
i
(t)| shares. If the cost to buy or sell one share of stock i
is
i
, then the transaction cost due to the changes of the inventory levels of the 7 stocks is
T(t) =
7

i=1

i
|I
i
(t + 1) I
i
(t)|P
i
(t).
The cumulative transaction cost at time t is the sum of transaction costs till time t:
C(t) =
t

s=N
estim
T(s).
We assume that the transaction costs are the same for the 7 stocks:

i
= .
We vary from 20 basis points (bps) to 50. Figure 3 shows the wealth growth over the
trading period for dierent levels of transaction cost. The nal wealth depends very much
on transaction cost. When it is below 35 basis points, this strategy outperformed signif-
icantly the S&P 500 index which yielded an annualized return of below 6% and a SR of
0.2 over the same period. Several empirical studies show that for S&P 500 index stocks,
the average transaction cost is below 35bps Gatev et al. (2006). This gure shows that
even the straightforward implementation of the dynamic trading strategy without taking an
appropriate measure for transaction costs appears to deliver a signicant performance.
Table 3 summarizes the performance of the dynamic trading strategy with dierent trans-
action cost levels. The maximum drawdown is relatively low, compared with that of the S&P
500 index over the same period (around 18%). The realized SR exceeds one when the av-
erage transaction cost is below 30 bps. So long as the transactio cost was below 35 bps, it
signicantly outperformed the S&P 500 index, whose performance over the same period is
summarized in Table 4.
The dynamic trading strategy balances the inventory levels of the 7 stocks daily, which
incurs signicant transaction costs. Figure 4 shows the plots of the cumulative wealth, W(t)
and the cumulative transaction cost, C(t) for two values of the average transaction cost for
S&P 500 index stocks. In the case of 25 basis points, the cumulative transaction cost over
the two-year trading period is comparable to the amount of wealth increased over the same
period. In the case of 35 basis points, the cumulative transaction cost easily exceeds even the
initial capital. In summary, the dynamic trading strategy with even a modest risk aversion
parameter exhibits an extremely high turnover rate.
From now on, we focus on the case of = 25. The results shown below are not signicantly
aected by the transaction cost, so long as it is within the range of 20 to 35.
17
PSfrag
time
r
e
l
a
t
i
v
e
w
e
a
l
t
h
1/2007 1/2008
0.5
1.0
1.5
2.0
2.5
20 bps
25 bps
30 bps
35 bps
40 bps
45 bps
50 bps
Figure 3: Cumulative return (geometric compounding of daily returns) of the dy-
namic trading strategy with = 70 and the four spreads in Table 2 over the trading
period versus transaction cost.
transaction
cost (bps)
annualized
return [%]
annualized
risk [%]
annualized
SR
maximum
drawdown [%]
20 56.61 32.20 1.43 16.75
25 46.64 32.20 1.23 17.43
30 37.30 32.21 1.02 18.11
35 28.54 32.22 0.82 18.78
40 20.34 32.23 0.61 19.44
45 12.66 32.25 0.41 20.11
50 5.46 32.26 0.20 21.09
Table 3: Performance of the dynamic trading strategy with = 70 and the four
spreads in Table 2 as transaction cost increases from 20 bps to 50 bps.
annualized
return [%]
annualized
risk [%]
annualized
SR
maximum
drawdown [%]
4.98 15.84 0.14 18.6
Table 4: Performance of the S&P 500 index over the period from June 2006 through
May 2008.
18
year
[
1
0
7
]
$
0
0.5
1.0
1.5
2.0
2.5
wealth
cumulative transaction
cost
2.5
year
[
1
0
7
]
$
1/2007 1/2008
0
0.5
1.0
1.5
2.0
wealth wealth
cumulative transaction
cost
cumulative transaction
cost
Figure 4: Time plots of wealth and cumulative transaction cost. Top: average trans-
action cost for S&P 500 index stocks is 25 basis points. Bottom: average transaction
cost for S&P 500 index stocks is 35 basis points.
19
standard deviation of daily returns [%]
m
e
a
n
o
f
d
a
i
l
y
r
e
t
u
r
n
s
[
%
]
1 1.5 2 2.5 3
0
0.1
0.2
0.3
Figure 5: Risk and return with varying risk aversion parameter. Dashdot curve: one
pair (HD/LOW). Dashed curve: two pairs (HD/LOW and PEP/PBG). Dotted curve:
three pairs (HD/LOW, PEP/PBG, and F/GM). Solid curve: four pairs (HD/LOW,
PEP/PBG, F/GM, HD/MAS).
Risk-return prole versus the number of spreads
Figure 5 shows how the risk-return prole of the dynamic trading strategy varies as the
number of spreads included varies from one to four. We can see that the performance is im-
proved, as the number of spreads increases from one to two. For other possible combinations
of the four pairs in Table 2, we observed a similar result. As can be seen from this gure,
the risk aversion parameter does not signicantly aect the realized SR. As decreases, the
realized risk and return as well as the margin requirement increase, regardless of the number
of spreads used.
20
PSfrag
return in percentage
-10 -5 0 5 10 15
0
5
10
15
20
25
30
35
Figure 6: Histogram of daily returns achieved by the dynamic trading strategy with
= 70 for the trading period from June 2006 to May 2008.
Shapes of return distributions
Figure 6 shows the histogram of the return distribution for = 70 when the average transac-
tion cost is 25 bps. It is clear that the return distribution is far from Gaussian. The skewness
of the distribution is 0.86, which means that i.e., the right tail is longer than the left one.
The kurtosis is 7.22, which means that the daily return distribution is leptokurtic, i.e., it has
a very acute peak around the mean, compared with a normally distributed random variable.
For a wide range of risk aversion parameters, we observed that the return distribution is
leptokurtic and skewed to the right.
21
Margin requirement
Figure 8 shows the allocations of wealth over the risk-free asset and risky assets. Here,
1 h(t)
T
S(t)/W(t) is the fraction of wealth put in the risk-free asset and h(t)
T
S(t)/W(t)
is the fraction of wealth put in the stocks (which can be negative). This gure shows that
over the trading period, the strategy always takes a short position in aggregate in the risky
assets.
The dynamic trading strategy is a type of long/short strategy, so the margin requirement
is more complicated than long-only strategies. As in Khandani and Lo (2007), we compute
the margin requirement for a broker/dealer, who is not subject to Regulation T (that species
the maximum initial credit extension by brokers/dealers that may be given to investors in
securities) and hence can employ higher levels of leverage than individual investors. We
assume a scenario in which the fraction of wealth in the money market account can be used
as collateral to nance the long/short positions in the underlying 7 stocks. The amount of
investment in the long or short position in stock i is |P
i
(t)I
i
(t)|. The total exposure is the
sum

7
i=1
|P
i
(t)I
i
(t)|. Using the leverage ratio of :1, the margin requirement at time t is
given by
MR(t) =
1

i=1
|P
i
(t)I
i
(t)|.
(This leverage ratio means that if = 8, then the margin to maintain a portfolio of risky
securities with 100 million dollar total exposure is 12.5 million.)
Figure 7 shows the time plot of the margin requirement computed with = 8 (which
is the same regulatory leverage factor as one used in Khandani and Lo (2007) to compute
the margin requirement for market-neutral long/short portfolios). The relative risk-aversion
parameter is taken as = 70. The gure shows that the margin requirement is always
met. When the relative risk-aversion parameter is below a threshold (around 40 in the
setting described above), the margin requirement based on the 8:1 ratio is not always met.
We conclude that margin requirements prevent the investor from being too aggressive in
exploiting the mean-revering behavior of the spreads.
Inventory levels
Figure 9 shows how the number of units of each of the four spreads varies over the trading
period. We can see from the gure that the allocations on the four spreads are well diversied.
Figure 10 shows the time plots of the inventory levels for the stocks in the pairs divided by
the current wealth, I(t)/W(t). This gure shows that the dynamic trading strategy changes
the inventory levels often abruptly (since it does not account for transaction costs). At the
peak, the daily transaction volume due to the dynamic strategy accounts for more than 1%
of the volume of a stock. The high volume means that the dynamic trading strategy is not
highly scalable. If the initial wealth were 100 million dollars, then at the peak the daily
transaction volume due to the dynamic strategy would account for more than 10% of the
volume of a stock, which calls special attention to price impact which is not modeled in the
present numerical study.
22
year
1/2007 1/2008
-1.0
-0.5
0
0.5
1.0
1.5
2.0
Figure 7: Relative allocation of wealth on the money market account and the
four spreads. Solid curve: the fraction of wealthy in the money market account,
1 h(t)
T
S(t)/W(t). Dashed curve: the fraction of wealth in the four spreads,
h(t)
T
S(t)/W(t).
year
[
$
]
1/2007 1/2008
0
0.5 10
7
1.0 10
7
1.5 10
7
2.0 10
7
2.5 10
7
3.0 10
7
Figure 8: Daily margin requirement. Solid curve: amount of money in the money
market account W(t) h(t)
T
S(t). Dashed curve: time plot of margin requirement
MR(t).
23
year year
year year
HD/LOW PEP/PBG
F/GM HD/MAS
1/2007 1/2007
1/2007 1/2007
1/2008 1/2008
1/2008 1/2008
-0.1 -0.1
-0.1 -0.1
-0.05 -0.05
-0.05 -0.05
0 0
0 0
0.05 0.05
0.05 0.05
0.1 0.1
0.1 0.1
Figure 9: Time plots of relative allocations on spreads, h(t)/W(t). Top left:
HD/LOW. Top right: PEP/PBG. Bottom left: F/GM. Bottom right: HD/MAS.
24
year
s
h
a
r
e
s
[
1
0
6
]
1/2007 1/2008
-1
0
1
HD
year
s
h
a
r
e
s
[
1
0
6
]
1/2007 1/2008
-1
0
1
LOW
year
s
h
a
r
e
s
[
1
0
6
]
1/2007 1/2008
-1
0
1
PEP
year
s
h
a
r
e
s
[
1
0
6
]
1/2007 1/2008
-1
0
1
PBG
year
s
h
a
r
e
s
[
1
0
6
]
1/2007 1/2008
-1
0
1
F
year
s
h
a
r
e
s
[
1
0
6
]
1/2007 1/2008
-1
0
1
GM
year
s
h
a
r
e
s
[
1
0
6
]
1/2007 1/2008
-1
0
1
MAS
Figure 10: Time plots of inventory levels. Top left: HD/LOW. Top right: PEP/PBG.
Bottom left: G/GM. Bottom right: HD/MAS.
25
stock
maximum daily inventory
level change [shares]
average daily inventory
level change [shares]
average transaction
volumes [shares]
HD 3.51 10
5
1.54 10
4
1.23 10
7
LOW 3.97 10
5
1.78 10
4
8.31 10
6
PEP 1.48 10
5
0.55 10
4
4.57 10
6
PBG 2.68 10
5
0.99 10
4
1.12 10
6
F 3.89 10
5
1.22 10
4
3.37 10
7
GM 1.30 10
5
0.41 10
4
1.23 10
7
MAS 4.93 10
5
2.03 10
4
3.05 10
6
Table 5: Maximum inventory level changes and average transaction volumes over the
trading period (from June 2006 through May 2008).
Transaction volumes and scalability
At time t (or the tthe trading date from the start of the trades), the daily inventory level
stock i changes from I(t 1) to I
i
(t). The daily inventory level change of stock i is therefore
M
i
(t) = |I
i
(t) I(t 1)|.
As can be seen from Figure 10, the inventory levels of the stocks often change abruptly over
the trading period.
Table 5 shows the maximum daily inventory level changes as well as the average daily
inventory level changes over the trading period (with N
trading
= 4 251 and N
trading
= 2 251
days). For comparison, it also shows the average transaction volumes of the stocks over the
same period. with the average transaction volumes of the stocks. The average daily inventory
level changes are below one percent of the average daily transaction volumes, so the inventory
level changes would not have price impact on average. For PBG and MAS (which are less
liquid compared with the other 5 stocks), however, their daily inventory level changes the
dynamic trading strategy requires are often not small, compared with their average daily
transaction volumes. For these stocks, price impact due to the large transaction volumes of
the dynamic trading strategy will often be noticeable.
As the capital deployed in the spreads and risk-free asset increases, daily transaction
volumes increase proportionately. Although the S&P 500 index stocks used in our numerical
study are quite liquid, the size of a fund that can be eectively run by the dynamic spread
trading strategy is limited. To make the trading strategy more scalable, it is necessary to
take into account price impact in the stochastic control formulation.
Eects of estimation horizon size and terminal time
Two important parameters in the dynamic spread trading strategy to be chosen are the
estimation horizon size and terminal time. The choice of the estimation horizon size aects
the accuracy of the estimate of the model parameters: when it is too small or large, the
26
estimation error can be signicant due to the small sample problem of the (possibly) time-
inhomogeneous characteristics of the spreads. (Another source of estimation error is model
mis-specication, which we do not address in this paper.) The choice of the terminal time
controls the signicance of the intertemporal component relative to the myopic component
over the trading period.
Thus far, the estimation horizon size has been xed to four years. We vary the parameter
from two years to four years, while xing the last date of the estimation period and the start
date of the trading period to the same values. (For instance, when the estimation horizon
size is two years, we use the stock data over the period of June 2004 to June 2006 to estimate
the cointegrating relations and model parameters.) Table 6 summarizes the results. When
the window size is below 3 years, the estimation error appears to be signicant, so the
performance is degraded accordingly.
Thus far, the terminal time (at which the wealth is evaluated) has been the same as
the last trading date. We next examine how the choice of the terminal time aects the
performance, as it varies from 2 years to 5 years. Table 7 summarizes the results. As the
terminal time increases, the return increases at the expense of increased risk. The SR remains
almost the same, regardless of the terminal time. The maximum drawdown increases almost
proportionately as the risk level increase. In summary, as T increases, the eect of the
intertemporal component becomes more signicant, and the realized risk and return tend to
increase.
Summary
We have thus far carried out an extensive numerical study for the dynamic spread trading
strategy with four pairs. The results show that the trading strategy could deliver a good
performance under realistic transaction costs. However, its large daily transaction volumes
mean that it is not highly scalable.
The experimental results shown above should be interpreted with caution. The mean-
reverting relationship on which the dynamic trading strategy and its good performance is
based may break down in the future. Unlike Siamese twin stocks (e.g., Royal Dutch/Shell
and Unilever NV/PLC) that should respond almost identically to news regarding intrinsic
value due to their nearly identical risk exposures, the mean-reverting statistical patterns in
the four pairs might be very vulnerable to shocks. In cases when many of the statistical
patterns break simultaneously, the dynamic spread trading strategy may suer signicant
losses.
27
estimation horizon
size [years]
annualized
return [%]
annualized
risk [%]
annualized
SR
maximum
drawdown [%]
2 52.5 52.6 0.99 28.4
2.5 60.3 54.2 1.07 25.4
3 58.3 46.3 1.14 22.6
3.5 56.1 39.2 1.23 16.7
4 55.5 39.1 1.22 22.1
Table 6: Eects of estimation horizon size on the performance of the dynamic spread
trading strategy over the two-year trading period (from June 2006 through May 2008).
terminal time
[years]
annualized
return [%]
annualized
risk [%]
annualized
SR
maximum
drawdown [%]
2 46.6 32.2 1.23 17.4
2.5 51.5 36.0 1.23 20.0
3 55.5 39.1 1.22 22.1
3.5 58.8 41.7 1.22 23.9
4 61.5 43.8 1.22 25.4
4.5 63.8 45.6 1.22 26.6
5 65.7 47.0 1.23 27.7
Table 7: Eects of trading horizon size on the performance of the dynamic spread
trading strategy over the two-year trading period (from June 2006 through May 2008).
28
5 Conclusions
In this paper, we have described a dynamic long/short trading strategy that exploits the
mean-revering characteristics of certain combinations of those. This strategy is not nec-
essarily market neutral or dollar neutral in a strict sense. We should point out that in
estimating the coecient vectors that specify the spreads, we can take into explicit account
market and/or sector exposures.
Although our (small-scale) experiments using a straightforward implementation of the
optimal feedback law (without taking any measures towards reducing the eects of trans-
action costs) show its good performance under realistic transaction costs, trading prots
appear to be signicantly eroded by transaction costs. We would like to include transaction
costs in the stochastic control formulation of dynamic spread trading. The corresponding
HJB equation is not analytically solvable, so the optimal feedback law should be computed
numerically. In the standard portfolio optimization setting with geometric Brownian motion,
David and Norman (1990) and Liu (2004) show that there is an inaction region where no
trading is performed. It is an interesting question whether the optimal feedback control law
for dynamic spread trading under transaction costs has an inaction region. We also would
like to develop a numerical method for solving the HJB equation.
Another interesting research direction is related to the wealth eect in convergence trad-
ing. Xiong (2001) studies convergence trading with one spread and logarithmic utility in a
continuous-time equilibrium model and shows that when an unfavorable shock causes con-
vergence traders to suer capital losses, they liquidate their positions, amplifying the original
shock. and, in extreme circumstances, causing them to be destabilizing in that they trade in
exactly the same direction as noise traders. It is an interesting question whether the benet
of diversication (over the multiple spreads) can mitigate the wealth eect in trading with
multiple spreads.
Acknowledgments
This material is based upon work supported by the Focus Center for Circuit & System Solu-
tions (C2S2), by the Precourt Institute on Energy Eciency, by Army award W911NF-07-
1-0029, by NSF award 0529426, by NASA award NNX07AEIIA, by AFOSR award FA9550-
06-1-0514, and by AFOSR award FA9550-06-1-0312.
29
A Derivation
A.1 Derivation of the ODEs for CRRA utility functions
We derive the ODEs in Section 3.2.
The case of = 1
In this case, the rst and second derivatives of the value function (5) are given by
V
t
(t, W, S) = S
T

A(t)S +

b(t)
T
S + c(t),
V
W
(t, W, S) = W
1
,
V
S
(t, W, S) = 2A(t)S +b(t),
V
WW
(t, W, S) = W
2
,
V
WS
(t, W, S) = 0,
V
SS
(t, W, S) = 2A(t).
The HJB equation (4) then becomes
S
T

A(t)S +

b(t)
T
S + c(t) +r + [2A(t)S +b(t)]
T
K(

S S) +Tr(
T
A(t))
+
1
2
[(K(

S S) rS)]
T

1
[(K(

S S) rS)] = 0.
Since this equation holds for any S R
m
, the three ODEs (7)(9) must hold for the functions
A, b, and c.
The case of = 1
In this case, the rst and second derivatives of the value function (5) are given by
V
t
(t, W, S) = V (t, W, S)
_
S
T

A(t)S +

b(t)
T
S + c(t)
_
,
V
W
(t, W, S) = (1 )W
1
V (t, W, S),
V
S
(t, W, S) = V (t, W, S) [2A(t)S +b(t)] ,
V
WW
(t, W, S) = (
2
)W
2
V (t, W, S),
V
WS
(t, W, S) = (1 )W
1
V (t, W, S) [2A(t)S +b(t)] ,
V
SS
(t, W, S) = V (t, W, S) [2A(t)S +b(t)] [2A(t)S +b(t)]
T
+ 2V (t, W, S)A(t).
The HJB equation (4) is then equivalent to
1
2V
WW
_
V
W
(K(

S S) rS) + V
SW

1
_
V
W
(K(

S S) rS) + V
SW

= V (t, W, S)g(t, S)
T

1
g(t, S),
30
where
g(t, S) = K(

S S) rS + (2A(t)S +b(t)).
Therefore,
S
T

A(t)S +

b(t)
T
S + c(t) + (1 )r + [2A(t)S +b(t)]
T
K(

S S)
+
1
2
Tr
_

T
_
(2A(t)S +b(t)) (2A(t)S +b(t))
T
+ 2A(t)
_

_
g(t, S)
T

1
g(t, S) = 0.
Since this equation holds for every S R
m
, the three ODEs (10)(12) must hold for the
functions A, b, and c.
A.2 Derivation of the ODEs for CARA utility functions
In this case, the rst and second derivatives of the value function (5) are given by
V
t
(t, W, S) = V (t, W, S)
_
S
T

A(t)S +

b(t)
T
S + c(t) +

d(t)
_
,
V
W
(t, W, S) = c(t)V (t, W, S),
V
S
(t, W, S) = V (t, W, S) [2A(t)S +b(t)] ,
V
WW
(t, W, S) = c(t)
2
V (t, W, S),
V
WS
(t, W, S) = c(t)V (t, W, S) [2A(t)S +b(t)] ,
V
SS
(t, W, S) = V (t, W, S) [2A(t)S +b(t)] [2A(t)S +b(t)]
T
+ 2V (t, W, S)A(t)
The associated HJB equation is then equivalent to
V (t, W, S)
_
S
T

A(t)S +

b(t)
T
S + c(t) +

d(t) +c(t)rW + [2A(t)S +b(t)
T
K(

S S)
+
1
2
Tr
_

T
(2A(t) + [2A(t)S +b(t)][2A(t)S +b(t)]
T
)
_

1
2
[K(

S S) rS + (2As +b)]
T

1
[K(

S S) rS + (2As +b)]
_
= 0.
Since this equation holds for every S R
m
and W R, the four ODEs (15)(18) must hold
for the functions A, b, c, and d.
31
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