Optimal trading with mean-reverting prices: switching between foreign stocks and closed-end country funds
We develop a model based on options theory which shows the optimal trading strategy for switching between two similar assets when the difference in their prices is mean-reverting. Statistical tests indicate that most closed-end country funds' discounts are mean-reverting. Using empirical estimates of the volatility and rate of mean reversion of these funds, we derive the optimal switch points and simulate the trading profits associated with switching between country funds and their foreign equities (and vice versa) whenever the optimal switch points are reached.
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