Speculative Futures Trading Under Mean Reversion

Asia-Pacific Financial Markets, pp 1-24, April 2016

22 Pages Posted: 27 Nov 2015 Last revised: 29 May 2016

See all articles by Tim Leung

Tim Leung

University of Washington - Department of Applied Math

Jiao Li

Columbia University

Xin Li

Columbia University

Zheng Wang

Columbia University

Date Written: November 25, 2015

Abstract

This paper studies the problem of trading futures with transaction costs when the underlying spot price is mean-reverting. Specifically, we model the spot dynamics by the Ornstein-Uhlenbeck (OU), Cox-Ingersoll-Ross (CIR), or exponential Ornstein-Uhlenbeck (XOU) model. The futures term structure is derived and its connection to futures price dynamics is examined. For each futures contract, we describe the evolution of the roll yield, and compute explicitly the expected roll yield. For the futures trading problem, we incorporate the investor's timing option to enter or exit the market, as well as a chooser option to long or short a futures upon entry. This leads us to formulate and solve the corresponding optimal double stopping problems to determine the optimal trading strategies. Numerical results are presented to illustrate the optimal entry and exit boundaries under different models. We find that the option to choose between a long or short position induces the investor to delay market entry, as compared to the case where the investor pre-commits to go either long or short.

Keywords: optimal stopping, mean reversion, futures trading, roll yield, variational inequality

JEL Classification: C41, G11, G13

Suggested Citation

Leung, Tim and Li, Jiao and Li, Xin and Wang, Zheng, Speculative Futures Trading Under Mean Reversion (November 25, 2015). Asia-Pacific Financial Markets, pp 1-24, April 2016, Available at SSRN: https://ssrn.com/abstract=2695405 or http://dx.doi.org/10.2139/ssrn.2695405

Tim Leung (Contact Author)

University of Washington - Department of Applied Math ( email )

Lewis Hall 217
Department of Applied Math
Seattle, WA 98195
United States

HOME PAGE: http://faculty.washington.edu/timleung/

Jiao Li

Columbia University ( email )

292C S.W. Mudd Building
500 West 120th Street
New York, NY NY 10027
United States

Xin Li

Columbia University ( email )

345 S.W. Mudd Building
500 West 120th Street
New York, NY 10027
United States

HOME PAGE: http://www.columbia.edu/~xl2206/

Zheng Wang

Columbia University ( email )

345 S.W. Mudd Building
500 West 120th Street
New York, NY 10027
United States

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