Optimal Convergence Trading with Unobservable Pricing Errors

We study a dynamic portfolio optimization problem related to convergence trading, which is an investment strategy that exploits temporary mispricing by simultaneously buying relatively underpriced assets and selling short relatively overpriced ones with the expectation that their prices converge in the future. We build on the model of Liu and Timmermann (2013) and extend it by incorporating unobservable Markov-modulated pricing errors into the price dynamics of two co-integrated assets. We chara...