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High Dimensional Statistical Arbitrage With Factor Models and Stochastic Control

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Applied Mathematical Finance

ISSN: 1350-486X (Print) 1466-4313 (Online) Journal homepage: https://www.tandfonline.com/loi/ramf20

High-dimensional Statistical Arbitrage with Factor


Models and Stochastic Control

Jorge Guijarro-Ordonez

To cite this article: Jorge Guijarro-Ordonez (2019) High-dimensional Statistical Arbitrage with
Factor Models and Stochastic Control, Applied Mathematical Finance, 26:4, 328-358, DOI:
10.1080/1350486X.2019.1702067

To link to this article: https://doi.org/10.1080/1350486X.2019.1702067

Published online: 22 Dec 2019.

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APPLIED MATHEMATICAL FINANCE
2019, VOL. 26, NO. 4, 328–358
https://doi.org/10.1080/1350486X.2019.1702067

High-dimensional Statistical Arbitrage with Factor Models


and Stochastic Control
Jorge Guijarro-Ordonez
Department of Mathematics, Stanford University, Stanford, CA, USA

ABSTRACT ARTICLE HISTORY


The present paper provides a study of high-dimensional statis- Received 4 June 2019
tical arbitrage that combines factor models with the tools from Accepted 2 December 2019
stochastic control, obtaining closed-form optimal strategies KEYWORDS
which are both interpretable and computationally implementa- Statistical arbitrage; factor
ble in a high-dimensional setting. Our setup is based on models; algorithmic trading;
a general statistically constructed factor model with mean- Ornstein-Uhlenbeck process;
reverting residuals, in which we show how to construct analyti- mean reversion; stochastic
cally market-neutral portfolios and we analyse the problem of control
investing optimally in continuous time and finite horizon under
exponential and mean-variance utilities. We also extend our
model to incorporate constraints on the investor’s portfolio
like dollar-neutrality and market frictions in the form of tempor-
ary quadratic transaction costs, provide extensive Monte Carlo
simulations of the previous strategies with 100 assets, and
describe further possible extensions of our work.

1. Introduction
Modelling of pairs trading based on stochastic control has been an active research
topic in mathematical finance for the last few years. After the papers by Jurek and
Yang (2007) and Mudchanatongsuk, Primbs, and Wong (2008), an increasing
number of models have been proposed in this framework (see, for example, Chiu
and Wong (2011), Tourin and Yan (2013), and Liu and Timmermann (2013)), in
which generally they assume that some statistically designed relation between the
prices of two assets is a mean-reverting stochastic process and find a dynamic
optimal allocation in continuous time in some version of the classical Merton
framework. More recently, a number of papers have also studied the optimal
entry and exit points when trading a couple of cointegrated assets, such as Leung
and Li (2015), Lei and Xu (2015), Ngo and Pham (2016), and Kitapbayev and Leung
(2018).
In the high-dimensional case, however, relatively little model-based research has
been conducted. Cartea and Jaimungal (2016) and Lintilhac and Tourin (2016)
investigate a multidimensional generalization of the model in Tourin and Yan
(2013) and apply stochastic control to solve a Merton-like problem in continuous

CONTACT Jorge Guijarro-Ordonez jguiord@stanford.edu Department of Mathematics, Stanford University,


Stanford, CA, USA
© 2019 Informa UK Limited, trading as Taylor & Francis Group
APPLIED MATHEMATICAL FINANCE 329

time on a collection of cointegrated assets, with exponential utility and finite


horizon. In a different direction which is not exactly statistical arbitrage, Cartea,
Gan, and Jaimungal (2018) address an optimal execution problem with transaction
costs on a basket of multiple cointegrated assets, which they also solve with control
techniques. Finally, without using stochastic control, the paper by Avellaneda and
Lee (2010) carries out a data-based study of statistical arbitrage in the US equity
market by proposing a factor model with mean-reverting residuals and a threshold-
based bang-bang strategy. This model is further analysed and extended by
Papanicolaou and Yeo (2017), who discuss risk control and develop an optimization
method to allocate the investments given the trading signals.
The previous papers in this high-dimensional framework thus either apply sto-
chastic control to a mean-reverting process they already have or use a factor model
to construct this process and then choose the trading signals based on residuals, but
none of them considers the combination of these two powerful techniques. The
present paper aims to fill this gap by providing a study of statistical arbitrage in
a high-dimensional setting that combines factor models and the tools from stochas-
tic control, generalizing and extending the previous studies and obtaining closed-
form optimal strategies which are interpretable and easy to implement
computationally.
More precisely, in our framework, an investor observes the returns of a high-
dimensional collection of risky assets and, similar to Avellaneda and Lee (2010) and
Papanicolaou and Yeo (2017), uses historical data to statistically construct a factor
model such that the cumulative residuals are assumed to be mean-reverting and
following an Ornstein-Uhlenbeck process. However, unlike the previous literature,
these residuals may be correlated and interdependent and, based on their behaviour,
the investor must decide how to optimally allocate her wealth in the risky assets and
a riskless security so that the expected utility of her terminal wealth is maximized
and she is market-neutral. There are three main results in this paper:
First, for a big class of statistically constructed factor models that includes PCA
we show how the investor may theoretically construct market-neutral portfolios
without solving any optimization problem (unlike the approach followed in
Papanicolaou and Yeo (2017) or Boyd et al. (2017), for example) provided that
the factor model holds, and we show how this makes the optimal allocation
problem analytically tractable and guarantees market-neutrality by construction.
These portfolios are explicitly computable and depend quadratically on the factor
model loadings and, to the best of our knowledge, using this construction to
connect factor models and stochastic control theory in statistical arbitrage is new.
Second, using these explicit market-neutral portfolios as control variables, we
show how the investor should trade optimally in continuous time to maximize
either an exponential utility or a Markowitz-inspired mean-variance objective,
obtaining explicit analytic forms of the optimal strategies in both cases in this high-
dimensional setting. The structure of these optimal strategies is related to the
classical solution of the Merton problem and is affine in the deviation of the
residuals from their statistical mean, thus giving a precise estimate of how much
we should buy when the assets are underpriced and how much we should sell when
they are overpriced, as in classical pairs trading. The coefficients are given by the
330 J. GUIJARRO-ORDONEZ

solution of matrix Riccati differential equations and depend quadratically on the


factor model loadings, and the strategies in both the exponential and the mean-
variance case are surprisingly similar except for a non-myopic correction term that
does not appear in the classical framework under a geometric Brownian motion.
This arises from the fact that in our case, the drift of the underlying Ornstein-
Uhlenbeck process is stochastic.
The structure and the techniques to find these affine strategies are thus similar in
spirit to those in the affine process literature in finance (see Duffie, Filipovic, and
Schachermayer (2003) for a broad survey), to the more recent affine control litera-
ture in algorithmic trading (see, for example, Cartea, Jaimungal, and Peñalva (2015)
and the references therein), and to the literature on extensions of the Merton
problem incorporating an Ornstein-Uhlenbeck process (see, for example, Benth
and Karlsen (2005), Liang, Yuen, and Guo (2011), Fouque, Papanicolaou, and
Sircar (2015) and Moutari, Sandjo, and Colin (2017), which deal with a single
risky asset in the context of the Schwarz model or in geometric Brownian motion
with stochastic drift or volatility; and Brendle (2006) and Bismuth, Guéant, and Pu
(2019), which consider the multiasset case again in the setting of geometric
Brownian motion with stochastic drift). While the techniques that we use to find
the optimal strategies are therefore classical, the framework is new because the
mean-reverting behaviour of the underlying stochastic process arises from the
residuals of a factor model and in the context of statistical arbitrage, and we
consider the general case of an arbitrary number of assets with a market-
neutrality restriction. Moreover, the explicit solutions allow us to understand the
dependence of the optimal strategies on specific elements of a statistical arbitrage
strategy (such as the factor model, its loadings matrix and its connection with
market-neutrality, and the mean-reversion speed of the residuals and their correla-
tion structure), and to compare arbitrageurs with exponential and mean-variance
utilities.
Third and finally, we extend the previous results in two directions by discussing
how to incorporate into the model soft constraints frequently imposed by arbitra-
geurs (such as dollar-neutrality, limitations on the money spent on each asset,
leverage restrictions, etc.) and also market frictions in the form of quadratic
transaction costs, inspired by the papers of Garleanu and Pedersen (2013, 2016)
and also by the more general quadratic transaction cost and linear price impact
literature in portfolio theory (see, for example, Moreau, Muhle-Karbe, and Soner
(2017) and Muhle-Karbe, Liu, and Weber (2017) for some new research directions
and Obizhaeva and Wang (2013), Rogers and Singh (2010), Almgren and Chriss
(2001) and Bertsimas and Lo (1998) for some classical papers). In both extensions,
we again find explicit analytic strategies which are easily interpretable, and which
quantitatively correspond to quadratic corrections in the structure of the original
optimal strategies (when adding soft constraints like dollar neutrality) or to ‘track-
ing’ averages of the future original optimal portfolios (when adding quadratic
transactions costs). Moreover, in both cases, these new strategies depend quadrati-
cally on the loadings of the factor model. Again, the novelty of the results comes
from the study of these questions (dollar neutrality, transaction costs, etc.) in a new
context in which they are crucial (statistical arbitrage with an arbitrary number of
APPLIED MATHEMATICAL FINANCE 331

assets and a market-neutrality restriction, in particular using control techniques and


a factor model), and this framework and the strategies that we find are new to the
best of our knowledge.
To conclude the paper with a more empirical analysis, we also perform extensive
numerical simulations with a high-dimensional number of assets (100). This gives
further insights about the behaviour of the previous strategies that are not obvious
when looking at the corresponding equations, and allows us to understand the sensitivity
of the model parameters and the dependence on the underlying factor model. This high-
dimensional numerical study is also new with respect to the existing literature, and the
main conclusions are that (1) the exponential-utility strategies are more profitable than
the mean-variance strategies (and they also take more extreme positions), (2) after some
initial up and downs the sample paths of the different wealth processes progressively
stabilize due to the asymptotic properties of the Ornstein-Uhlenbeck process, (3) increas-
ing the risk-control parameters (like the parameter controlling dollar neutrality) con-
sistently produces a concentration of the distribution of the terminal wealth around
smaller values, and (4) imposing market neutrality when the loadings of the factor model
get bigger leads to more aggressive strategies whose terminal wealth has a higher
variance.
The remainder of the article is organized as follows. In section 2, we introduce our
model, construct the market-neutral portfolios that make the problem analytically
tractable and formulate the control problems. Next, section 3 presents the basic results
under the exponential and the mean-variance frameworks, whereas section 4 extends
these results by considering the addition of soft constraints and of quadratic transaction
costs. Section 5 then allows us to understand in greater depth the behaviour of the
previous strategies and models by performing some Monte Carlo simulations, and
section 6 presents the main conclusions and proposes future new directions of research.
Finally, an Appendix contains all the proofs.

2. The model
2.1. Set-up and assumptions
In the remainder of this paper, we will consider the following general framework.
We will assume that an investor observes the returns of a large number N of risky
assets and, like in classical portfolio theory based on stochastic control, she must
decide how to dynamically allocate her wealth by investing in them or in a riskless
asset with constant interest rate r so that the expected utility of her wealth at a finite
terminal time T is maximized. However, unlike the classical framework and the
existing literature, to do so she will execute a statistical arbitrage strategy based on
a factor model, in which instead of trading depending on the state of the original
returns she will trade depending on the behaviour of the residuals, which will be the
trading signals. For example, in the case of two assets, this is equivalent to classical
pairs trading, in which the investor may perform a simple linear regression on the
returns of two historically correlated securities and, depending on how far the
oscillation of the residual is from its historical average, she decides if there is
a mispricing and opens and closes long and short positions in the original assets
332 J. GUIJARRO-ORDONEZ

in a market-neutral way. In this paper, we will study the generalization of this to the
high-dimensional case of an arbitrary number of assets, in which we substitute the
simple linear regression by a statistical factor model and we study the optimal
allocations under the framework of stochastic control, assuming a mean-reverting
stochastic model for the behaviour of the residuals.
More precisely, we make the following three general assumptions on how the investor
will generate these residuals and what dynamics they will have:
(1) Assumption 1: The investor has computed a factor model for the returns of the
risky assets, which will hold during the investment (finite) horizon and is given by
dRt ¼ ΛdFt þ dXt ; (2:1)

where Rt is the cumulative asset returns process, Λ is the (constant-in-time)


loadings matrix, Ft is the cumulative factors process, and Xt is the cumulative
residuals process1.
(2) Assumption 2: This factor model has been computed statistically by using some
version of PCA2, so the rows of Λ are the largest eigenvectors of some square
matrix and the discrete-time version of dFt (i.e., the daily, hourly, etc., factors
returns) is then computed by linearly regressing the discrete-time version of dRt
(i.e., the daily, hourly, etc., assets returns) on some rescaling of Λ, so
~ t
dFt ¼ ΛdR (2:2)

for some rescaling Λ ~ of Λ. (In fact, the only thing we need about this assumption is
that (2.2) holds for some matrix Λ, ~ which allows for a bigger class of factor models
than classical PCA).
(3) Assumption 3: The process Xt given by the cumulative residuals is mean-reverting.
In particular, for analytic tractability, we assume that it is a matrix N-dimensional
Ornstein-Uhlenbeck process satisfying the following stochastic differential equation
with known parameters
dXt ¼ Aðμ  Xt Þdt þ σdBt ;

where A is a constant N-dimensional square matrix whose eigenvalues have


positive real parts so that there is mean-reversion, μ is a constant N-dimensional
vector, Bt is a vector of m independent Brownian motions in the usual complete
filtered probability space ðΩ; F ; P; ðF t Þ0tT Þ, and σ is a constant N  m matrix
such that the instantaneous covariance matrix σσ 0 is invertible.

The previous framework thus combines high-dimensional statistical arbitrage,


factor models and stochastic control in a way which is new to the best of our
knowledge, and it extends several models in the existing literature. For example,
statistical arbitrage models based on a more particular case of Assumptions 1, 2, 3
(in which the residuals are assumed to be independent one-dimensional Ornstein-
Uhlenbeck processes, so A and σ are diagonal) and in which no stochastic control
methods are applied have been studied empirically in the US equity market by
Avellaneda and Lee (2010) and Papanicolaou and Yeo (2017). In a different
direction, if we consider the particular case of removing the factor model by
APPLIED MATHEMATICAL FINANCE 333

making Λ ¼ 0, we have the situation in which the returns themselves are globally
mean-reverting following a matrix Ornstein-Uhlenbeck process, which has also
been studied empirically and analytically using stochastic control techniques in the
context of optimal execution in Cartea, Gan, and Jaimungal (2018), and in the
context of statistical arbitrage in Cartea and Jaimungal (2016) in the particular
case in which A has rank one.

2.2. Making the model tractable for stochastic control and imposing
market-neutrality
Unlike the classical literature on portfolio choice based on stochastic control,
choosing as control variables the amount of capital that the agent invests in each
of the N risky assets of the previous framework might make the optimal allocation
problem intractable. Indeed, since we only have information about the dynamics of
the residuals (and not directly about the returns like in the classical framework),
these residuals are not independent, and the factors themselves depend on the
returns, the classical approach would lead to complicated interdependencies.
Moreover, since the investor is executing a statistical arbitrage strategy, we would
need to incorporate additional market-neutrality constraints so that the returns of
the strategy do not depend on the model factors, but just on the idiosyncratic
component of the model given by the residuals. This would complicate the problem
further and might require numerical optimization methods as done in Papanicolaou
and Yeo (2017) and Boyd et al. (2017).
In this paper, on the contrary, we deal with both problems simultaneously and we
solve them analytically by following a new approach. This is based on the following
proposition, which shows that, by using the N risky assets at our disposal, it is actually
possible to construct analytically N market-neutral portfolios whose returns only depend
on one coordinate of X, which greatly simplifies the complexity of the problem and makes
it analytically tractable:

Proposition 2.1. Under the previous assumptions, it is possible to construct explicitly N


market-neutral portfolios such that investing any real number πit of dollars in the i-th one
at time t yields an instantaneous return of πit dXti (and hence a combined return of
πt  dXt ).
Moreover, the total amount of capital invested at time t by doing so is πt  p for an
explicit constant-in-time vector p 2 R N , which depends quadratically on the factor model
loadings.

Proof. The mathematical construction of the market-neutral portfolios under the given
assumptions is surprinsingly straightforward and involves just a linear projection.
Indeed, (2.1) implies that
X
dRti ¼ Λij dFtj þ dXti ;
j

whereas (2.2) yields


334 J. GUIJARRO-ORDONEZ

X
dFtj ¼ ~ jk dRtk :
Λ
k
P
Combining the two previous equations we find that, for cik :¼ j Λ ~ jk Λij ,
!
X X X
dRti ¼ ~ jk Λij dRtk þ dXti ¼
Λ cik dRtk þ dXti :
k j k

Thus, if at time t we hold the (explicitly constructible) constant-in-time portfolio


given by
~pi :¼ ðci1 ; ci2 ; . . . ; ci;i1 ; 1  cii ; ci;iþ1 ; . . . ; ciN Þ

(i.e., we invest  ci1 dollars in the first asset,  ci2 dollars in the second one, and so on),
we automatically obtain an instantaneous return of dXti , which is market neutral and
depends only on the ith coordinate of the process Xt . Further, from the above equations it
is also obvious that for any real number πit , πit ~pi will
Palso be market-neutral and yielding
a return of πit dXti , and the same applies to ~
i π it pi , which will have a return
P
of i πit dXti ¼ πt  dXt .

Finally, regarding the last part of the statement just observe that the total amount of
capital invested in the strategy πt ¼ ðπit Þ1iN at time t is simply
X X
ðπit ~pi Þ  1 ¼ πit ð~pi  1Þ ¼ πt  p
i i

where p :¼ ð~pi  1Þ1iN , which concludes our proof. □

Remark 2.1. Note in particular that, if Λ or Λ~ are sparse matrices, then most of the cik in
the above construction will be 0, so the investor will be investing in a few number of
assets in each market-neutral portfolio and this could significantly reduce his transaction
costs while rebalancing his positions. In particular, Pelger and Xiong (2018) discuss a way
of obtaining this kind of sparse factor model.

The key consequence of the above proposition is that, if we choose as control variables
the amount of capital πt that we wish to invest in these N market-neutral portfolios
(instead of directly in the original assets) at time t, the dynamics of the problem get
remarkably simpler, they only depend separately on the coordinates of X, and we have
market-neutrality by construction. This solves simultaneously the two problems we
discussed before and allows us to connect stochastic control and the factor model in
a simple way, and it is therefore the approach which we will adopt in the remainder of
this paper.
Note also that, under these new control variables, all the information about the factor
model and in particular about its loadings matrix is now encoded in the vector p, which
will play an important role in the remaining sections. Moreover, some statements about
the strategies must be rewritten in terms of it within this new framework. For instance, in
the new setting, a strategy ðπt Þ0tT is dollar-neutral at t if p  πt ¼ 0, since as we
mentioned before p  πt is the total capital spent at time t.
APPLIED MATHEMATICAL FINANCE 335

2.3. Formulation of the control problems


Under the previous framework, now we formulate rigorously the control problems we
will study in the paper. We suppose that the investor executes the following trading
strategy: at each time t 2 ½0; T, she invests πt dollars in the risky market-neutral
portfolios we constructed in Proposition 2.1, and she invests her remaining wealth (or
borrow money if the remaining wealth is negative) in the risk-free asset with constant
interest rate r, so that the resulting strategy is self-financing. Thus, assuming for the
moment, no market frictions or other constraints (which will be both considered in
section 4), the evolution of her wealth is given by the equation,
dWt ¼ πt  dXt þ ðWt  πt  pÞrdt (2:3)
and she aims to choose πt to maximize the expected utility of her terminal wealth (that is,
uðWT Þ for a given utility function u).
Supposing further that she trades continuously in time, this means that mathemati-
cally she must solve the high-dimensional non-linear stochastic optimization problem
given by,
Hðt; x; wÞ ¼ sup Et;x;w ½uðWT Þ (2:4)
π2A½t;T

subject to
dWt ¼ ðπt0 Aðμ  Xt Þ þ ðWt  πt0 pÞrÞdt þ πt0 σdBt

dXt ¼ Aðμ  Xt Þdt þ σdBt ;


where the admissible set A½t;T is the set of all the F s -predictable and adapted processes
"ð #
T
2
ðπs Þs2½t;T in R with the minimal technical restrictions that E
N
jjπs jj ds < 1 (so Ito’s
t
formula may be applied and doubling strategies are excluded) and the above SDEs have
a unique (strong) solution, and 0 indicates transposition.
Finally, the associated dynamic programming equation of the problem is non-linear
and ðN þ 2Þ-dimensional, and is given by
1
0 ¼ @t H þ ðμ  xÞ0 A0 Ñx H þ Trðσσ 0 Ñxx HÞ þ
 2  (2:5)
0 0 1 0 0 0 0
sup ðπ Aðμ  xÞ þ ðw  π pÞrÞ@w H þ π σσ π@ww H þ π σσ Ñxw H
π 2
with terminal condition HðT; x; wÞ ¼ uðwÞ.
The problem is therefore formally related to the classical Merton framework, but
instead of a geometric Brownian motion, there is a multidimensional Ornstein-
Uhlenbeck process which makes it impossible to combine the dynamics of W and X
into a single equation and to get rid of the N-dimensional state variable x.
Moreover, unlike the previous studies on extensions of the Merton problem with
an Ornstein-Uhlenbeck process discussed in section 1, in (2.4) and (2.5) the mean-
reverting behaviour of the underlying stochastic process arises in the context of
statistical arbitrage and from the residuals of a factor model (which is encoded in
336 J. GUIJARRO-ORDONEZ

the vector p of the equations above and which will play an important role in the
following sections), and we consider the general case of an arbitrary number of
assets with a market-neutral restriction. Furthermore, the model will be extended in
section 4 to incorporate other important features of statistical arbitrage strategies,
like dollar neutrality restrictions and transaction costs, and we will analyse the
impact of the factor model on these extensions.
Quite surprisingly, the previous problems admit interpretable closed-form solu-
tions – which is computationally useful in this high-dimensional setting, and which
allows us to understand the influence of the model parameters and especially of the
factor model – in the cases in which the utility is exponential or of a Markowitz-
inspired mean-variance type (but not for other usual choices of utility functions, like
the HARA family). This is what we will show in the following two sections, first for
the simple setup of (2.4) and (2.5) in section 3, and then extending the model in
section 4 to incorporate soft constraints on the investor’s portfolio and quadratic
transaction costs.

3. The frictionless results


In this section we therefore present the closed-form, optimal strategies for the problem
given by (2.4) and (2.5) in the cases in which the utility is exponential or of a mean-
variance type, discussing the former in the first subsection and the latter in the second
one. While the techniques that we use are classical, in both cases, the explicit solutions
allow us to gain insight on the new framework of statistical arbitrage with a factor model
and will be the basis for the extensions of section 4.

3.1. The exponential utility case


In this first setting, the complete, explicit description of the optimal strategy is given by
the following main theorem (see Cartea and Jaimungal (2016) and Lintilhac and Tourin
(2016) for related results with an exponential utility):

Theorem 3.1. Under an exponential utility (so uðwÞ ¼ eγw for some γ > 0) and the
technical condition described in our verification theorem (Proposition 3.2 below), the
optimal portfolio to have at time t according to (2.4) is explicitly computable and given by
!
0 1 Aðμ  Xt Þ  pr A0 ðσσ 0 Þ1 ðT  tÞ2
πt ¼ ðσσ Þ þ ðAðμ  Xt Þ  prÞðT  tÞ  Apr :
γerðTtÞ γerðTtÞ 2

The result follows from the following two propositions, whose proof is given in
Appendix A.1 using classical stochastic control techniques:

Proposition 3.1 (Solving the PDE). The value function H associated to (2.4) and (2.5)
when uðwÞ ¼ eγw is explicitly computable and admits the probabilistic representation
Hðt; x; wÞ ¼  expðγðwerðTtÞ þ hðt; xÞÞÞ where
APPLIED MATHEMATICAL FINANCE 337

"ð #
T
1 0 0 1
hðt; xÞ ¼ Et;x ðAðμ  Ys Þ  prÞ ðσσ Þ ðAðμ  Ys Þ  prÞ ds
t 2γ

and dYt ¼ rpdt þ σdBt for a new Brownian motion B under a new probability law P .
The associated optimal control in feedback form is then
DH
π ¼ ðσσ 0 Þ1 (3:1)
@ww H
where DH ¼ ðAðμ  xÞ  prÞ@w H þ σσ 0 Ñxw H.

Proposition 3.2 (Verification). The strategy given in Theorem 3.1. is indeed optimal if

4 max jjΛ0 ðsÞjj < 1 and 32 max jjΛ1 ðsÞjj < 1;


0sT 0sT

where Λ0 ðsÞ and Λ1 ðsÞ are the diagonal matrices containing, respectively, the eigenvalues of
Ω1=2 ðC0 þ C00 ÞΩ1=2 ðsÞ and Ω1=2 C1 C10 Ω1=2 ðsÞ, for
C0 ðsÞ ¼ A0 ðσσ 0 Þ1 AðIN þ AðT  sÞÞ; C1 ðsÞ ¼ A0 ðσσ 0 Þ1 ðIN þ AðT  sÞÞσ
ðs
0
ΩðsÞ ¼ eAðsuÞ σσ 0 eA ðsuÞ du:
0

Besides being a closed-form strategy which is easily implementable in our high-


dimensional setting, the above optimal portfolio is also interpretable. Indeed, the first
term of the optimal policy is Merton-like in that it represents the drift of the underlying
process (which here is stochastic unlike in the classical geometric Brownian motion)
minus the adjusted risk-free rate (which here depends on the loadings of the factor model
via p), and divided by a measure of the volatility (which is given by σσ 0 , the instantaneous
quadratic covariation of X) and the Arrow-Pratt coefficient of absolute risk-aversion of
the value function with respect to the wealth w (i.e.,  @ww H=@w H), which is the product
γerðTtÞ , where γ is the risk aversion parameter of our utility function and the factor
erðTtÞ measures the gains from interest between t and T.
On the other hand, the second summand is a non-myopic correction term which again
depends linearly on the drift of X, and whose effect vanishes when we approach the
terminal time T. Moreover, note that, while the first term does not depend explicitly on
the terminal time T, this correction term does, reflecting the fact that, since there are
non-zero interest rates and moreover the behaviour of the residuals is oscillating, the
investor must keep in mind the final horizon to decide if she bets on the mean-reversion
cycle before that time. Finally, observe that, quite naturally, in both terms as the risk-
aversion parameter γ, the instantaneous volatility σσ 0 , or the interest rate r increase, the
optimal portfolio vector πt gets closer to 0, implying that the investor will simply invest
most of her wealth in the riskless asset.
The above strategy also seems intuitive within our particular framework of
statistical arbitrage with a factor model and sheds further light on the problem.
Indeed, note that the current state of the residual process Xt only appears in the
strategy through the terms in Aðμ  Xt Þ, which essentially tells us to invest more in
338 J. GUIJARRO-ORDONEZ

the risky assets the further their residuals are from their historical mean μ and in
a way proportional to the historical mean reversion speed given by A, like in
classical pairs trading. Moreover, all the remaining terms depend jointly on the
factor model and the interest rate through the term pr, which reflects the cost of
the leverage associated with imposing market-neutrality through the loadings of
the factor model. In particular, note that, the bigger the loadings of the factor
model are (and hence the bigger p is), the more we will need to invest to achieve
market neutrality (again like in pairs trading with a big beta) and the bigger our
leverage will be, and this will affect the optimal strategy depending on the interest
rate r.
Finally, regarding the technical optimality conditions, intuitively they arise from the
fact that Hðt; Xt ; Wt Þ, the value function evaluated at the wealth process Wt correspond-
ing to the optimal strategy, may blow up because of the exponential function coming
from the exponential utility. In particular, since Wt ends up being an Ito process
depending quadratically on Xt and Xt is Gaussian, the term expðγWt erðTtÞ Þ is related
to the moment generating function of a chi-squared distribution, which blows up far
away from 0. Thus, these technical conditions are just ensuring that the corresponding
functions are integrable. Interestingly, this does not depend on the risk-aversion para-
meter γ, the interest rate r, or the factor model used (captured by p), but just on the
parameters of X and the terminal time T.

3.2. The mean-variance case


In the second, Markowitz-inspired mean-variance framework, the investor tries to
maximize her expected terminal wealth but at the same time, she continuously penalizes
at each instant the instantaneous variance (i.e., the volatility) of her wealth process
according to a volatility-aversion function γðtÞ. The optimal strategy in this case is
again available in closed form and interpretable and, quite remarkably, for an appropriate
choice of this volatility-aversion function, we obtain exactly the same optimal policy as in
the exponential case but without the correction term. This is shown in the following
theorem, whose proof is given in Appendix A.2. using classical control techniques:

Theorem 3.2. If γðtÞ is continuous and positive on ½0; T, the problem in (2.4) with the
following mean-variance objective function
" ðT #
γðsÞ d
Hðt; x; wÞ ¼ sup Et;x;w WT  Vars ðWτ Þjτ¼s ds
π2At;T t 2 dτ

has explicit optimal portfolio at t given by

πt ¼ ðγðtÞσσ 0 Þ1 ðAðμ  Xt Þ  prÞerðTtÞ :

In particular, for γðtÞ ¼ γe2rðTtÞ , the above optimal policy is the same as the first term of
the corresponding one in Theorem 3.1.
This unexpected connection between the mean-variance and the exponential utility
cases may in fact be explained heuristically. Indeed, supposing that r ¼ 0 for the sake of
APPLIED MATHEMATICAL FINANCE 339

simplicity and considering a second-order approximation of the exponential we get 


expðγWT Þ  1 þ γWT  γ2 WT2 =2; and for maximization purposes when condi-
tioned on t this behaves essentially as Et;x;w ½γWT  γ2 Vart ðWT Þ=2. Rewriting this
variance as the integral of the corresponding instantaneous variances and dividing by γ
we obtain exactly the previous objective function, showing moreover that the correction
term of Theorem 3.1 that does not appear in this case is heuristically associated to the
moments of order higher than two of the exponential utility.
Regarding the interpretation of the mean-variance strategy within our context of
statistical arbitrage and its connection with the exponential-utility arbitrageur, there
are two important remarks.
First, as we mentioned, the optimal strategy here is the same as the myopic part of the
exponential case modulo the value of γðtÞ. In particular, this means that, unlike the
exponential arbitrageur, the mean-variance arbitrageur will not take into account the
expected number of mean-reversion cycles until the terminal time T. Moreover, for
a non-zero interest rate and a constant volatility aversion γðtÞ, the mean-variance
arbitrageur is bolder than the corresponding exponential investor with the same γ,
since she will invest significantly more money (quantitatively, by a factor of e2rðTtÞ ) in
going long or short, taking more aggressive positions the higher the interest rate is and
the sooner it is with respect to the terminal date.
Second, the optimal strategy has two components like in section 3.1: one term in
Aðμ  Xt Þ which measures how far the residuals are from their historical mean and how
fast they will mean-revert (like in classical pairs trading), and a second term in pr linked
to the factor model, which measures the cost of the leverage associated to imposing
market neutrality. In particular, note that, the bigger the loadings of the factor model are
(and hence the bigger p is), the more aggressive the positions will be and the more
leverage the investor will have if rÞ0.

4. Two extensions
In this final theoretical section of the paper, we complete the picture described in the
previous two sections by considering two important and new extensions within the
context of statistical arbitrage with a factor model. In the first subsection, we show
how to incorporate in the above strategies soft constraints frequently imposed by
arbitrageurs with the example of dollar-neutrality, whereas in the second one we
introduce market frictions in the form of quadratic transaction costs. In both cases,
we obtain again closed-form analytic solutions which are interpretable, convenient
from a computational perspective in our high-dimensional setting, and which shed
further light on the influence of the factor model and its connection with market
neutrality.

4.1. Incorporating soft constraints on the admissible portfolios


While imposing restrictions on the portfolios by introducing hard constraints directly on
the admissible set At;T leads in general to problems that must be solved numerically (and
hence potentially unfeasible in a high-dimensional setting), it is still possible to impose
340 J. GUIJARRO-ORDONEZ

many additional soft constraints in the two frameworks of section 3 without increasing
significantly the difficulty of the problems, by just adding a carefully chosen penalty term
to the corresponding objective function.
As an illustration of this, we give in the next corollary the corresponding optimal
strategies when a dollar-neutrality restriction is softly enforced. To do so, recall that,
within the framework of section 2 that imposed market-neutrality within the factor
model, a strategy πt is dollar neutral if p  πt ¼ 0, which means that the total amount
of capital invested at time t is 0. Hence, we can softly enforce dollar neutrality by
replacing the wealth process of Theorems 3.1 and 3.2 by the penalized wealth process
defined by dW ~ t :¼ dWt  αðtÞðπt  pÞ2 =2dt for a certain general time-dependent penalty
function αðtÞ. This penalizes non dollar-neutrality (i.e., πt  pÞ0) at each time and is
quadratic to simplify the optimization process.
The proof follows exactly the same lines as in the previous two cases and is obtained
from them by small modifications, so we will omit it for the sake of brevity.

Corollary 4.1. Suppose that dollar neutrality is softly enforced by replacing the wealth
process of Theorems 3.1 and 3.2 by the penalized wealth process defined by
dW~ t :¼ dWt  αðtÞðπt  pÞ2 =2dt. Then
(1) The problem with mean-variance utility has optimal portfolio at t given by

πt ¼ ðγðtÞσσ 0 þ αðtÞpp0 Þ1 ðAðμ  Xt Þ  prÞerðTtÞ :

(2) The problem with exponential utility has optimal portfolio at t given by

πt ¼ ðγerðTtÞ σσ 0 þ αðtÞpp0 Þ1 ðAðμ  Xt Þ  pr  γσσ 0 ðbðtÞ þ cðtÞXt ÞÞ:

where cðtÞ is an N  N symmetric matrix and bðtÞ is an N-dimensional vector,


vanishing when t ! T, and with coordinates depending on A; σ; rp; γ and αðtÞ. In
particular, cðtÞ is given by the solution of the matrix Riccati ODE

0 ¼ @t c  A0 c  cA  γcσσ 0 c þ erðTtÞ ðA þ γσσ 0 cÞ0 MðtÞðA þ γσσ 0 cÞ

and bðtÞ is the solution of the linear system of ODEs

0 ¼ @t b  A0 b þ cAμ  erðTtÞ ðA þ γσσ 0 cÞMðtÞðAμ  pr  γσσ 0 bÞ  γcσσ 0 b;

both with terminal conditions bðTÞ ¼ cðTÞ ¼ 0 and where MðtÞ ¼ ðγσσ 0
erðTtÞ þ αðtÞpp0 Þ1 .

The resulting optimal policies have therefore the same structure as the two previous
strategies of section 3, but now the additional term αðtÞpp0 has been introduced in the
inverse to enforce the dollar-neutrality condition. This again depends on the factor
model via p and is related to how extreme the capital positions will be because of the
market-neutrality restriction, which depends directly on the loadings matrix and hence
on p. Note in particular that, the bigger the loadings of the factor model are, the bigger
αðtÞpp0 will be and hence the bigger the impact of the dollar neutrality restriction
will be.
APPLIED MATHEMATICAL FINANCE 341

4.2. Incorporating quadratic transaction costs


In this subsection, we finally extend our model to incorporate market frictions in the
form of transaction costs, which play a crucial role when executing statistical arbitrage
strategies. We consider in particular quadratic transaction costs, which are in general
a measure of price impact or illiquidity and which make the model analytically tractable.
To do so, rather than looking directly at the amount of capital πt invested in the risky
assets at time t as the control variables, we consider instead the trading intensity It at
which these investments will be made at time t, which is therefore given by dπt ¼ It dt.
We can now adapt to our setting the model for temporary transaction costs introduced in
Garleanu and Pedersen (2016), who posit (providing a market microstructural justifica-
tion and referring to empirical research) that these transaction costs at time t may be
represented quadratically as It0 CIt for a certain symmetric positive-definite matrix C3,
which essentially comes from the assumption that the price impact of the investor’s
actions is linear on its trading intensity It .
Under this framework, we can then rewrite the performance criteria of Theorem 3.2
(for the sake of brevity, we will just deal with the mean-variance case) by incorporating
the adverse effect caused by these transaction costs on the investor’s wealth as a running
penalty, obtaining the stochastic optimization problem given by
" ðT ð #
γðsÞ d 1 T
Hðt; x; w; πÞ ¼ sup Et;x;w;π WT  Vars ðWτ Þjτ¼s ds  Is0 CIs ds (4:1)
I2A t 2 dτ 2 t

in which as we mentioned the new control variable is I; t; x; w; π are now state variables;
and A is the set of all F -adapted predictable processes It such that the corresponding
SDEs have a unique (strong) solution for any initial data and both It and the resulting πt
given by dπt ¼ It dt are again in L2 ðΩ  ½0; TÞ. Thus, the investor aims to maximize her
terminal wealth but penalizing at each instant both for the risk of her strategy (measured
by the volatility of her wealth process) and for the price impact caused by her actions
(reflected in the quadratic transaction costs).
In this new setting, it is again possible to find explicitly the optimal strategy that the
investor should follow, which is described in detail in the next theorem:

Theorem 4.1. If γðtÞ 0 (i.e., non-negative volatility aversion) and is continuous, the
optimal strategy in the above problem ‘tracks’ a moving aim portfolio Aimðt; Xt Þ with
a tracking speed of RateðtÞ, according to the following ODE describing the evolution of the
optimal trading intensity It ¼ dπt =dt
It ¼ Aimðt; Xt Þ þ RateðtÞπt ;
where RateðtÞ is a N  N negative-definite matrix tending to 0 when t ! T 4, and
Aimðt; Xt Þ admits the probabilistic representation
ðT
Aimðt; xÞ ¼ f ðsÞEt;x ½FrictionlessðsÞds
t

where FrictionlessðsÞ is the optimal portfolio at time s in the frictionless case of section 3.2.
and f ðsÞ is a certain averaging function given in Proposition 4.3 below.
342 J. GUIJARRO-ORDONEZ

Furthermore, the optimal portfolio is then,


ðs ð s 
πs ¼ πt þ : exp RateðvÞdv : Aimðu; Xu Þdu;
ð t t  u

where the notation : exp  ds : represents the time-ordered exponential5.


u

Remark 4.1. If in particular the investor has constant volatility aversion (so γðtÞ ¼ γ), the
matrix Riccati ODE is explicitly solvable and

RateðtÞ ¼ C1=2 D tanhðDðt  TÞÞC1=2


for D :¼ ðγC1=2 σσ 0 C1=2 Þ1=2 . Moreover, if the transaction costs are proportional to the
volatility (i.e., C ¼ λσσ 0 for λ > 0, see Garleanu and Pedersen (2013, 2016) for a market
microstructural justification) then this rate is indeed a scalar given by
qffiffi qffiffi 
γ γ
λ tanh λ ðt  TÞ
ð s  qffiffi  qffiffi 
γ γ
and : exp RateðvÞdv :¼ cosh λ ðs  TÞ = cosh λ ðu  TÞ .
u

The result follows from the following sequence of three propositions, which are
proved in Appendix A.3:

Proposition 4.1 (Conjectured solution). The solution of the HJB equation associated to
the problem is Hðt; x; w; πÞ ¼ erðTtÞ w þ 12 π0 aðtÞπ þ π0 bðt; xÞ þ dðt; xÞ if there exist a
N  N symmetric matrix aðtÞ, a N-dimensional vector bðt; xÞ and a scalar function
dðt; xÞ satisfying
(1) The matrix Riccati ODE
@t a  γðtÞσσ 0 þ aC1 a ¼ 0 (4:2)
with terminal condition aðTÞ ¼ 0.
(2) The vector-valued and the scalar linear parabolic PDEs

ð@t þ LX Þb þ erðTtÞ ðAðμ  xÞ  rpÞ þ a0 C1 b ¼ 0 (4:3)

1
ð@t þ LX Þd þ b0 C1 b ¼ 0 (4:4)
2
with terminal conditions bðT; xÞ ¼ dðT; xÞ ¼ 0 and where LX is the infinitesimal
generator of X, acting coordinatewise.
The hypothesized optimal trading intensity at ðt; x; w; πÞ is then I  ¼ C1 ðaðtÞπ þ bðt; xÞÞ.

Proposition 4.2 (Existence of solutions).


(1) If γðtÞ 0 (non-negative volatility-aversion) and is continuous, then the Riccati
equation (4.2) has a symmetric, bounded and negative definite solution on all ½0; T.
In particular, for γðtÞ ¼ γ, the solution is

aðtÞ ¼ C1=2 D tanhðDðt  TÞÞC1=2


for D :¼ ðγC1=2 σσ 0 C1=2 Þ1=2 .
APPLIED MATHEMATICAL FINANCE 343

(2) Moreover, under this condition the parabolic PDEs (4.3) and (4.4) have an unique
solution satisfying a polynomial growth condition in x, and this solution admits the
probabilistic representation
"ð ð s  #
T
bðt; xÞ ¼ Et;x : exp a0 ðuÞC1 du : erðTsÞ ðAðμ  Xs Þ  rpÞds (4:5)
t t

"ð #
T
1 0
dðt; xÞ ¼ Et;x bðt; Xs Þ C1 bðt; Xs Þds (4:6)
2 t

Furthermore, b has linear growth in x u and d has quadratic growth in x, both


uniformly in t.

Proposition 4.3 (Verification). Under the assumptions of the previous proposition, the
trading intensity given in Theorem 4.1 is indeed optimal with the choices

Aimðt; xÞ ¼ C1 bðt;


xÞ;
ð RateðtÞ ¼ C1 aðtÞ;
s
f ðsÞ ¼ C1 : exp RateðuÞ0 du : γðsÞσσ 0 :
t

The interpretation of the above strategy (which is again explicit and hence easily
implementable in practice) is again intuitive and complementary to the infinite-horizon
model of Garleanu and Pedersen: in the presence of temporary quadratic transactions
costs, the investor trades with a certain decreasing rate RateðtÞ towards an aim portfolio
Aimðt; Xt Þ depending on the time and the mean-reversion state of the signals Xt . This
aim portfolio is given by a weighted average of the future optimal strategies in the
frictionless case, reflecting the fact that now trading is not free and thus to enter
a trade the investor must weight the future outcomes derived from the strategy.
Moreover, as shown in the above remark, the trading rate is bounded by 1 because of
the properties of tanh , depends on t unlike the infinite-horizon case, and is naturally
decreasing in the transaction cost parameter λ (or in general in C) and increasing in the
volatility aversion parameter γ.

Finally, regarding the influence of the factor model and the imposition of market
neutrality in this new setting, note that RateðtÞ is insensitive to it (since it only depends
on the risk aversion parameter γ, the volatility of the residual process σσ 0 , and the
transaction cost matrix C) and in Aimðt; xÞ it only appears through the term
Et;x ½FrictionlessðsÞ and hence only when considering the future optimal strategies in
the frictionless case, which has been described in section 3. Likewise, the residual process
Xs only affects the strategy through this same term and hence, as seen in section 3 when
studying these frictionless cases, only through the distance between this residual and its
historical mean, like in classical pairs trading.
344 J. GUIJARRO-ORDONEZ

5. Monte Carlo simulations


We finally conclude the paper by providing some high-dimensional numerical simula-
tions that give new insights about the behaviour of the previously discussed strategies and
their sensitivity to the different parameters, emphasizing in a separate simulation the role
of the factor model and its connection with market-neutrality. To this end, we first
simulate a large number of paths of X in a high-dimensional setting (in particular, we
choose N ¼ 100) by using exact Monte Carlo sampling along a discrete-time grid, and we
then execute the previous strategies for some parametric choices of X and some values of
p to compute sample paths of πt and Wt and histograms of the terminal Profit & Loss
(P&L). We have therefore opted to defer systematic (out-of-sample) experiments with
real data to a separate paper, since examining carefully the delicate issues of asset
selection, rebalance frequency, construction of the factor models and obtention of X,
high-dimensional parameter estimation and updating, risk control, etc., that the problem
requires would be impossible to consider here without prohibitively extending the length
of the paper.
During all this section, we therefore fix the following parameters for our model:
N ¼ 100; μ ¼ 0; X0 ¼ μ;

A is diagonal with entries drawn i.i.d from a normal distribution of mean 0.5 and standard
deviation 0:1, and the coefficients of σ are drawn i.i.d from a uniform distribution in
½0:3; 0:3, except for the diagonal elements which are drawn from a uniform distribution
in ½0; 0:5. Furthermore, p ¼ 1 for the first simulations, and we will also perturb it later to
study different factor model regimes and the impact of imposing market neutrality. We
also fix a finite horizon of T ¼ 20 and a temporal grid 0 ¼ t0 < t1 < . . . tL ¼ T obtained by
discretizing ½0; T with constant Δt ¼ T=L ¼ 20=400 ¼ 0:5.
From a financial perspective, the above choice of parameters means that the 100
coordinates of X are correlated and mean-revert with similar speeds (given by the
eigenvalues of A) to an equilibrium of 0, describing an average number of approximately

Figure 1. Sample paths of the first four coordinates of X in ½0; T.


APPLIED MATHEMATICAL FINANCE 345

10 oscillation cycles of ups and downs before the terminal time (given by the product of T
and the average mean-reversion speed). The choice of p ¼ 1 arises when the asset returns
themselves are mean-reverting and may be modelled directly by X so we can take Λ ¼ 0
in our factor model, while the perturbations of p will imply departing from this assump-
tion to factor models with heavier loadings, in which imposing market neutrality leads to
more leveraged positions. As an illustration, the reader may look at sample paths of the
first four coordinates of such a process X in Figure 1.
We then sample M ¼ 1; 000 paths of X on this grid exactly with standard Monte Carlo
techniques by using the fact that, since
ð tþΔt
AΔt AΔt
XtþΔt ¼ e Xt þ ðI  e Þμ þ eAðΔtþtsÞ σdBs ;
t

XtþΔt jXt ,N ðμðXt ; ΔtÞ; ðΔtÞÞ, where


ð Δt
0
μðXt ; ΔtÞ ¼ eAΔt Xt þ ðI  eAΔt Þμ; ðΔtÞ ¼ eAðΔtsÞ σσ 0 eA ðΔtsÞ ds;
0

and execute the following strategies6 at the corresponding times tl ‘s, with W0 ¼ π0 ¼ 0
and πt constant between consecutive times:

(1) The exponential-utility strategy of Theorem 3.1 with γðtÞ ¼ 1; 2; 3; 4 and


r ¼ 0; 2%.
(2) The mean-variance utility strategy with dollar-neutrality penalty of Corollary 4.1.1
with γðtÞ ¼ 1; 2; 3; 4, αðtÞ ¼ 0; 20; 50 and r ¼ 2%.
(3) The mean-variance utility strategy with quadratic transaction costs of Theorem
4.1 with γðtÞ ¼ 1; 2; 3; 4, r ¼ 2%, and C ¼ λσσ 0 for λ ¼ 0:1; 0:5; 1.

Moreover, to study the result of imposing market-neutrality through the market-neutral


portfolios constructed in section 2 under different factor model regimes, we perform the
following additional simulation in which we experiment with the parameter p, which
encapsulates all the factor model information and which we perturb to simulate the effect
of going away from the case where the returns themselves are mean-reverting (which
corresponds to the previous case p ¼ 1) and of having progressively more leveraged (and
more extreme) market-neutral portfolios:
(4) The three strategies above with γðtÞ ¼ 1; αðtÞ ¼ 0 and r ¼ 2% (and λ ¼ 1 for the
third strategy) for p ¼ 1 þ a and a ¼ 1; 2; 4; 8, where a is a N-dimensional vector
whose components are drawn i.i.d. from a uniform distribution in ½a; a.

We finally present the simulated path of a sample wealth process ðWt Þt2½0;T , the
simulated path of the first coordinate of a sample allocation process ðπt Þt2½0;T , and the
histogram for the terminal wealth WT for each of the above cases in the following four
subsections, along with a final analysis:
346 J. GUIJARRO-ORDONEZ

5.1. Simulations of the exponential-utility strategy

(a) (b)

(c) (d)

(e) (f)
Figure 2. Results for the exponential utility.
APPLIED MATHEMATICAL FINANCE 347

5.2. Simulations of the mean-variance strategy with dollar neutrality

(a) (b) (c)

(d) (e) (f)

(g) (h) (i)


Figure 3. Results for the mean-variance utility when r ¼ 0:02 with different dollar-neutrality
restrictions.
348 J. GUIJARRO-ORDONEZ

5.3. Simulations of the mean-variance strategy with quadratic transaction costs

(a) (b) (c)

(d) (e) (f)

(g) (h) (i)


Figure 4. Results for the mean-variance utility when r ¼ 0:02 with different quadratic transaction
costs C ¼ λσσ0 .
APPLIED MATHEMATICAL FINANCE 349

5.4. Simulations for different factor model and market-neutrality regimes

(a) (b) (c)

(d) (e) (f)

(g) (h) (i)

Figure 5. Results for the three strategies above with different p‘s, when r ¼ 0:02; α ¼ 0; γ ¼ 1; λ ¼ 1.

5.5. Comparison of the simulated strategies


We now present our main conclusions after observing the previous plots, analysing the
behaviour of the histograms of the final wealth WT , the sample paths of the wealth process
ðWt Þt2½0;T , and the sample paths of the positions ðπ1t Þt2½0;T , with a final subsubsection
discussing the effect of imposing market-neutrality under different p‘s.

5.5.1. Histograms of the final wealth


Looking first at the above histograms (Figures 3–4(g–i), and 2(e–f)), we see that, for our
parametric choice and our setting in which X is effectively a multidimensional Ornstein-
Uhlenbeck process with known parameters,

(1) The most profitable strategy is the one derived from the exponential utility (Figure
2(e–f)) with the lowest risk-aversion parameter γ, even in the most adverse
scenarios of the histogram and both with and without zero interest rates.
350 J. GUIJARRO-ORDONEZ

Moreover, even for bigger values of γ this strategy significantly performs better
under any regime of r and α than the mean-variance strategy (Figure 3(g–i)).
(2) We observe the following outcomes when changing one of the parameters for each
of the three strategies (Figures 3–4(g–i), and 2(e–f)):
● Increasing the value of the risk-aversion parameter γ produces a concentration
of the density of WT around smaller values, i.e., the expected wealth decreases
and so does the dispersion around it.
● Increasing the dollar-neutrality penalty α has this same negative effect, but
makes little difference unless the increments in α are considerable.
● Increasing the value of the interest-rate r has an overall positive effect, which is
more pronounced in the mean-variance case (since as we mentioned at the end
of section 2.2 the investor is then bolder than the exponential agent).
● Increasing the transaction cost parameter λ decreases the expected terminal
wealth, but surprisingly it also skews its distribution producing a considerable
right-tail (whereas all the other distributions are essentially symmetric).
These outcomes have a natural interpretation: since the model is perfectly specified
and the parameters are known, the derived strategies will always produce benefits
by construction, and they will be bigger the fewer additional constraints we impose
(such as risk-aversion, dollar-neutrality, and transaction costs) and the more we
can take advantage of previous success (by increasing r). This situation, however,
might not apply under parameter misspecification, where the additional constrains
would help the investor mitigate the model risk.

5.5.2. Sample paths of the wealth process Wt


Examining next the sample paths for the particular simulation which is plotted
(Figures 3–4(a–c), and 2(a,b)), we can observe exactly the same patterns as discussed
in the previous paragraph when modifying the parameters γ; α, r and γ. There are,
however, two new and interesting remarks:

(1) In the three strategies, after an initial period of ups and downs and similarity
between the different strategies, there is a tendency towards stabilization because
of the asymptotic properties of the Ornstein-Uhlenbeck process, and of differ-
entiation depending on the parametric choices.
(2) This phenomenon is especially pronounced with the exponential utility and with
bigger values of r (Figure 2(a,b)) since it takes more aggressive positions, reflecting
the fact that sometimes the agent will invest more money than what she will make
at that moment (and sometimes even having temporary negative wealth and
borrowing aggressively) to continue executing the strategy.

5.5.3. Sample paths of the positionsπ1t


Considering now the plots of the sample paths of the positions π1t (Figures 3–4(d–f), and
2(c,d)), we similarly notice that

(1) The positions become more extreme when decreasing γ, α and λ (i.e., the risk-
aversion parameter, the non-dollar-neutrality penalty and the transaction cost
APPLIED MATHEMATICAL FINANCE 351

parameter) and when increasing r (the interest rate). The greatest overall impact is
produced by γ and λ and then r, especially in the mean-variance case for the same
reasons as before.
(2) The exponential-utility strategy takes much more extreme positions than the
mean-variance strategies, which in this idealized setting of perfect estimation
partially explains why the exponential agent obtains a greater wealth at the
terminal time.
(3) The cycles in the positions π1t match the oscillations of X1t depicted in Figure 1(d)
theoretically in the corresponding equations.

5.5.4. Effects of imposing market neutrality


Finally, looking separately at the effect of imposing market neutrality under various
factor model regimes depending on p (which, as we mentioned, depends quadratically on
the factor model loadings), we observe the following (Figure 5):

(1) As the parameter p gets bigger, the market neutral portfolios of section 2 become
more extreme and the adopted positions πt also become more aggressive, espe-
cially in the exponential-utility case (Figure 5(d–f)).
(2) Since the strategy is more aggressive but we have perfect calibration and estima-
tion, with bigger p the mean-variance and especially the exponential strategy
become more profitable. However, the wealth process also has more ups and
downs (Figure 5(a–c)), the standard deviation of the terminal wealth increases
considerably (Figure 5(g,h)), especially in the mean-variance case, and with the
biggest p there are also heavy losses when transaction costs are incorporated
(Figure 5(c–i)). The strategies are therefore riskier, but a relatively large value of
p is needed to appreciate its effect.
(3) Lastly, note that the influence of p on the strategies also depends most of the time
on the value of r, since they normally appear combined as a factor of rp in the
equations describing the strategies. In particular, when r ¼ 0 there is no theore-
tical effect associated to p (apart from possible model risk and high leverage in
a real-world setting) unless the dollar-neutrality parameter αðtÞÞ0.

6. Conclusions and further research


In this paper, we have aimed to provide a systematic study of high-dimensional
statistical arbitrage combining both stochastic control and factor models. To this
end, we have first proposed a general framework based on a statistically constructed
factor model, and then shown how to obtain analytically explicit market-neutral
portfolios and rephrase our problem in terms of them to make it tractable and get
market neutrality by construction. Using this insight, we have then been able to study
the question of optimizing the expected utility of the investor’s terminal wealth in
continuous time under both an exponential and a mean-variance objective. In both
cases, we have obtained explicit closed-form solutions ready for numerical implemen-
tation, analysed the corresponding strategies from the perspective of statistical arbit-
rage and the underlying factor model, and discussed extensions involving the addition
352 J. GUIJARRO-ORDONEZ

of soft constraints on the admissible portfolios (like dollar-neutrality) and the presence
of temporary quadratic transaction costs. Finally, we have run some high-dimensional
Monte Carlo simulations to explore the behaviour of the previous strategies, and
analysed their qualitative aspects and their sensitivity to the relevant parameters and
the underlying factor model.
There are four natural extensions to our work, on which we are conducting research at
the moment and which we intend to publish in separate papers. First, one could
investigate a more realistic version of the problem in which, rather than in continuous
time, the investor may only trade more realistically at an increasing sequence of optimally
chosen stopping times, generalizing in multiple directions the literature initiated by the
influential work of Leung and Li (2015) and developing robust and efficient numerical
methods. Second, it would be interesting to study more realistic modelizations of market
frictions, illiquidity, and transaction costs, or to develop a model considering issues of
parameter misspecification. Third, on a more empirical side and as we mentioned at the
start of section 5, one should consider in this setting the problems of construction of the
factor models, high-dimensional parameter estimation, and risk control, along with (out-
of-sample) experiments with real market data under the strategies developed in this
paper. Fourth and finally, one could study a more data-driven version of the problem,
where the fixed stochastic model is replaced by new tools from reinforcement learning.

Notes
1. Here we have decided to write the factor model in a somewhat unusual differential,
continuous-time form in terms of the cumulative residuals and returns because of nota-
tional simplicity for this section of the paper. In practice, however, the factor model will be
estimated in discrete time, by replacing the differentials by the corresponding discrete
increments (so, for instance, dRt should be replaced by the daily, hourly, etc., asset returns,
dFt would be just the corresponding daily, hourly, etc., factors returns, and so forth). In any
case we will only use this notation and framework in this section of the paper, and the reader
may look at Avellaneda and Lee (2010) for essentially the same continuous/discrete time
framework and some estimation techniques. Note also that the constant loadings assump-
tion is realistic in short time horizons.
2. See Lettau and Pelger (2018) and Pelger and Xiong (2018) for some new versions of high-
dimensional PCA that might be particularly interesting for this problem.
3. The assumption that C is symmetric is without loss of generality, since if the transaction
~ t for a non-symmetric C,
costs are given by It0 CI ~ then one can see that by considering the
~ ~ ~
symmetric part of C (given by C :¼ ðC þ C Þ=2) we have that It0 CI
0 ~ t ¼ I 0 CIt .
t
4. and given by the solution of a matrix Riccati ODE specified in the Porposition 4.2 below.
5. Recall that the time-ordered exponential of a time-dependent matrix AðsÞ is defined
ð t 
QP
as : exp AðsÞdsÞ :¼ limjjPjj#0 ni¼1 expðAðti ÞΔti , where P :¼ fu ¼ t0 ; t1 ; . . . ; tn ¼ tg
u
is a partition of ½u; t, Δti :¼ ti  ti1 , and the product is ordered increasingly in time.
ð t  ð t 
If AðsÞ is a scalar, then obviously : exp AðsÞds :¼ exp AðsÞds .
u u

6. We have just simulated some simple cases of the previously discussed strategies for space
limitation reasons, but of course, it would also be possible to include further constraints (like
a leverage restriction, for instance) or time-varying hyperparameters with no additional
effort, by just using the previously derived formulae. It would be interesting as well to
APPLIED MATHEMATICAL FINANCE 353

execute the strategies with some perturbations of the real parameters to simulate possible
microstructural noise and imperfect estimation.

Acknowledgments
The author would like to thank George Papanicolaou for suggesting the topic of the previous
research and for many insightful discussions about the problem and the presentation of the results,
and the editor and an anonymous reviewer for their very helpful suggestions to improve the
quality of the paper.

Disclosure statement
No potential conflict of interest was reported by the author.

ORCID
Jorge Guijarro-Ordonez http://orcid.org/0000-0002-6453-6563

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APPLIED MATHEMATICAL FINANCE 355

Appendix. Proofs
A.1 Proof of Theorem 3.1

As we mentioned, the techniques that we use to solve the HJB equation are classical and have been
addressed in the literature, so we just indicate the key steps for the reader’s convenience and refer
to some of the existing papers for more detail (cf., for example, the proofs of section 3.1 of
Bismuth, Guéant, and Pu (2019) for a similar PDE but in the context of portfolio choice under
a geometric Brownian motion with stochastic drift, or Benth and Karlsen (2005), Liang, Yuen, and
Guo (2011) and Tourin and Yan (2013) for related equations in the case of one or two assets).

Proof of Proposition 3.1:


The optimal control is obtained by just looking at the first-order condition of the term inside the
supremum in (2.5). Plugging it back, we get the non-linear ðN þ 2Þ-dimensional PDE

1 DH 0 ðσσ 0 Þ1 DH
0 ¼ @t H þ ðAðμ  xÞÞ0 Ñx H þ Trðσσ 0 Ñxx HÞ þ wr@w H  : (A:1)
2 2@ww H
Considering now the classical ansatz Hðt; x; wÞ ¼  expðγðwerðTtÞ þ hðt; xÞÞÞ for some func-
tion hðt; xÞ to be determined and such that hðT; xÞ ¼ 0, we get rid almost miraculously of the non-
linearity and obtain the ðN þ 1Þ-dimensional linear parabolic equation,
1 1
0 ¼ @t h þ Trðσσ 0 Ñxx hÞ þ rp0 Ñx h þ ðAðμ  xÞ  prÞ0 ðσσ 0 Þ1 ðAðμ  xÞ  prÞ:
2 2γ

Finally, we solve this explicitly by using the Feynman-Kac formula, yielding the probabilistic
representation for h given in the proposition’s statement and the closed-form expression,
1
hðt; xÞ ¼ ðAμ  prÞ0 ðσσ 0 Þ1 ðAμ  prÞðT  tÞ

ð T  ð T 
1 1 1
 ðAμ  prÞ0 ðσσ 0 Þ1 AEt;x Ys ds þ Et;x Ys0 A0 ðσσ 0 Þ AYs ds ;
γ t 2γ t

where
ð T  ðT
ðT  tÞ2
Et;x Ys ds ¼ Et;x ½Ys ds ¼ xðT  tÞ þ rp
t t 2

and
ð T 
1
Et;x Ys0 A0 ðσσ 0 Þ AYs ds ¼ x0 A0 ðσσ 0 Þ1 AxðT  tÞ þ
t

  ðT  tÞ2 ðT  tÞ3
1 1
þ 2x0 A0 ðσσ 0 Þ Arp þ Trðσ 0 A0 ðσσ 0 Þ AσÞ þ r2 p0 A0 ðσσ 0 Þ1 Ap ;
2 3
using that Ys ¼ x þ rpðs  tÞ þ σðBs  Bt Þ for s t and

E ½ðBs  Bt Þ0 σ 0 A0 ðσσ 0 Þ1 AσðBs  Bt Þ ¼ ðs  tÞTrðσ 0 A0 ðσσ 0 Þ1 AσÞ:


Proof of Proposition 3.2:
Following the mentioned literature, we just have to check that π 2 A½0;T and that the function H
derived in Proposition 3.1 is indeed the value function of the stochastic control problem.
356 J. GUIJARRO-ORDONEZ

As for the first issue, from its explicit expression π is obviously F t -adapted and predictable (in
fact, it has continuous paths) and, using the trivial inequalities jjx þ yjj2  2jjxjj2 þ 2jjyjj2 and
ðT
jjAxjj  jjAjjjjxjj and the fact that Xt is a Gaussian process, it is easy to see that E½jjπs jj2 ds < 1.
0
Moreover, applying Ito’s formula to the process ert Wt yields,

dðert Wt Þ ¼ rert Wt dt þ ert dWt ¼ πt  ert dXt  πt  ert prdt


and, therefore,
ð t ðt 
Wt ¼ w þ ert πs  ers dXs  πs  ers prds (A:2)
0 0

for any t 0 and any admissible control π. Thus, the SDE for W has a unique strong solution W 
for the particular case π ¼ π for any initial data, given by the above integral.
As for the second part, we simply adapt the proof of Theorem 2.1. of Lintilhac and Tourin
(2016) for a related model, which guarantee the uniform P-integrability of the family of random
variables ðHðτ; Xτ ; Wτ ÞÞτ2½0;T where τ is a F -stopping time, and which we simply adapt to the
parameters of the present model obtaining the sufficient conditions stated in Proposition 3.2.
The key observation to adapt their proof is that in our case we also have that the hypothesized
value function is of the form Hðt; x; wÞ ¼  expðγwerðTtÞ  12 x0 A2 ðtÞx  A1 ðtÞx  A0 ðtÞÞ for
some explicit smooth functions Ai ðtÞ that we computed in the proof of Proposition 3.1, and our X
is also a matrix Ornstein-Uhlenbeck process under P with SDE dXt ¼ Aðμ  Xt Þdt þ σdBt , and
ðτ ðτ
γWτ erðTτÞ ¼ γwerðTτÞ þ γ πs  erðTsÞ ðAðμ  Xs Þ  prÞds þ γ πs  erðTsÞ σdBs
0 0

as we showed in (A.2). Thus, using the Cauchy–Schwarz inequality as in their proof, the part
corresponding to  12 Xτ0 A2 ðτÞXτ  A1 ðτÞXτ  A0 ðτÞ in the above expression for Hðτ; Xτ ; Wτ Þ
may be bounded exactly as they do. As for the part corresponding to  γWτ erðTτÞ , we can again
repeat their exact reasoning, but noting that the quadratic term in Xs in the first integral above is
now Xs0 C0 ðsÞXs for the matrix C0 ðsÞ that we defined before, and likewise, the term in Xs in
the second integral is Xs0 C1 ðsÞ, which following their proof gives, respectively, the two explicit
sufficient conditions that we stated in Proposition 3.2. ⁏

A.2 Proof of Theorem 3.2


The proof technique is again classical (see, for example, Cartea, Jaimungal, and Peñalva (2015) for
similar techniques), so we just indicate the key steps and use a verification theorem from the
literature.
The HJB equation is now,
1
0 ¼ @t H þ ðμ  xÞ0 A0 Ñx H þ Trðσσ 0 Ñxx HÞ þ
2
 
0 0 1 0 0 0 0 γðtÞ 0 0
sup ðπ Aðμ  xÞ þ ðw  π pÞrÞ@w H þ π σσ π@ww H þ π σσ Ñxw H  π σσ π
π 2 2
with terminal condition HðT; x; wÞ ¼ w:
Guessing the quadratic ansatz Hðt; x; wÞ ¼ werðTtÞ þ aðtÞ þ bðtÞ0 x þ 12 x0 cðtÞx for a scalar aðtÞ,
an N-dimensional vector bðtÞ, and a symmetric N  N matrix cðtÞ, and plugging this into the
above equation, we obtain the hypothesized optimal control given in the statement of the
theorem and the above PDE gets reduced to the following system of three first-order linear
matrix ODEs
APPLIED MATHEMATICAL FINANCE 357

0 ¼ @t c  A0 c  cA þ e2rðTtÞ A0 ðγðtÞσσ 0 Þ1 A

0 ¼ @t b  A0 b þ cAμ  e2rðTtÞ A0 ðγðtÞσσ 0 Þ1 ðAμ  prÞ

1 1 e2rðTtÞ
0 ¼ @t a þ ðμ0 A0 b þ b0 AμÞ þ Trðσσ 0 cÞ þ ðAμ  prÞ0 ðγðtÞσσ 0 Þ1 ðAμ  prÞ
2 2 2
with terminal conditions aðTÞ ¼ bðTÞ ¼ cðTÞ ¼ 0.
This system has an explicit bounded solution in ½0; T, since the classical solutions of the general
first-order linear matrix ODEs @t y þ uy þ vðtÞ ¼ 0 and @t y þ uy þ yu0 þ vðtÞ ¼ 0 with yðTÞ ¼ 0
are given, respectively by,
ðT ðT
yðtÞ ¼ expððs  tÞuÞvðsÞds and yðtÞ ¼ expððs  tÞuÞvðsÞ expððs  tÞu0 Þds
t t

if vðsÞ is continuous on ½0; T.


Thus, the HJB equation has an explicit classical solution which has quadratic growth in the state
variables uniformly in t. A classical verification result (cf. for example Theorem 4.3 of Guyon and
Labordère (2013)) then yields that our hypothesized optimal control is indeed optimal provided
that it is admissible, which may be checked exactly as in the proof of Theorem 3.1. ⁏

A.3 Proof of Theorem 4.1


Proof of Proposition 4.1:
The corresponding dynamic programming equation is, in this case,
1
0 ¼ ð@t þ LX ÞH þ ðπ0 Aðμ  xÞ þ ðw  π0 pÞrÞ@w H þ π0 σσ 0 π@ww H þ
2
 
γðtÞ 0 0 1
þ π0 σσ 0 Ñxw H  π σσ π þ sup I 0 Ñπ H  I 0 CI ;
2 I 2
with terminal condition HðT; x; w; πÞ ¼ w and where the supremum is obviously attained at
I  ¼ C1 Ñπ H. Substituting this back in the above equation, plugging the stated ansatz, and
matching the coefficients for π0 ðÞπ, π0 ðÞ and the constant yields the above differential
equations.

Proof of Proposition 4.2:


(1) The first statement follows directly from the result for comparison and existence of solutions
of matrix Riccati ODEs given by Theorem 2.2.2 in Kratz (2011), since the matrix Riccati
ODE,

@t a þ aC1 a ¼ 0
with terminal condition aðTÞ ¼ 0 has the obvious symmetric solution aðtÞ ¼ 0 defined on
all ½0; T. Thus, (4.2) has a symmetric classical solution aðtÞ defined on all ½0; T with a  0,
which is bounded because ½0; T is compact and a is differentiable hence continuous.
As for the particular solution when γðtÞ ¼ γ, simply note that pre- and post-multiplying
(4.2) by C1=2 and defining ~a :¼ C1=2 aC1=2 gives the new Riccati,

@t ~a  γC1=2 σσ 0 C1=2 þ ~a2 ¼ 0;


whose solution is ~aðtÞ ¼ D tanhðDðt  TÞÞ.
(2) The existence of solutions with polynomial growth and their probabilistic representa-
tion in the above form follow from a vector-valued version of the Feynman-Kac
358 J. GUIJARRO-ORDONEZ

theorem (see, for example, Appendix A.3 of Cartea, Gan, and Jaimungal (2018) for
a proof of how to adapt the one-dimensional case).
The fact that b has linear growth in x uniformly in t is then a consequence of the
probabilistic representation (4.5). Indeed, Fubini’s theorem implies that,
ðT ð s 
bðt; xÞ ¼ : exp a0 ðuÞC1 du : erðTsÞ ðAEt;x ½μ  Xs   rpÞds
t t

whereas the fact that


ð tþΔt
AΔt AΔt
XtþΔt ¼ e Xt þ ðI  e Þμ þ eAðΔtþtsÞ σdBs
t

yields,

Et;x ½μ  Xs  ¼ eAðstÞ ðμ  xÞ:


Combining the two pieces and using the boundedness of a and the compactness of ½0; T
gives the desired uniform bound in t.
The quadratic growth of d in x uniformly in t is then obvious looking at its probabilistic
representation and using the linear growth of b. □

Proof of Proposition 4.3:


Combining the two previous propositions, we have already found an explicit classical solution of
the associated HJB equation with quadratic growth in the state variables uniformly in t, so using
again Theorem 4.3 in Guyon and Labordère (2013), we just have to verify that the candidate
intensity given in Proposition 4.1 is admissible.
For this, first note that the corresponding SDEs controlled by the above intensity have an unique
(strong) solution for any initial data. Indeed, given I  and the definition of I as dπ ¼ Idt, we can
solve explicitly the corresponding first-order linear matrix ODE for π yielding, for s t,
ðs ð s 
πs ¼ πt þ : exp RateðvÞdv : Aimðu; Xu Þdu;
t u

 
and this π in turn defines W like in the proof of Theorem 3.1.
Finally, from the above construction it is obvious that both πt and It are F t -adapted and
predictable (in fact, they have continuous paths), and the property that π is in L2 ð½0; T  ΩÞ (i.e.,
ðT
that E½jjπs jj2 ds < 1) stems from the observation that RateðuÞ is deterministic and bounded
0
(because of Proposition 4.3.1), Aimðt; xÞ has linear growth in x uniformly in t (by Proposition
4.3.2), and X is a Gaussian process (so it is in L2 ð½0; T  ΩÞ).
It is likewise in L2 ð½0; T  ΩÞ since, as we saw in Proposition 4.1, It ¼ C1 ðaðtÞπt þ bðt; Xt ÞÞ
and we can therefore use the triangular inequality, the just shown fact that πt is in L2 ð½0; T  ΩÞ,
and the same arguments as above that aðtÞ is bounded (because of Proposition 4.3.1), that bðt; xÞ
has linear growth in x uniformly in t (by Proposition 4.3.2), and that X is a Gaussian process, to
conclude. □

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