Portfolio choice with cointegrated assets

In portfolio management, there are specific strategies for trading between two assets that are cointegrated. These are commonly referred to as pairs-trading or spread-trading strategies. In this paper, we provide a theoretical framework for portfolio choice that justifies the choice of such strategies. For this, we consider a continuous-time error correction model to model the cointegrated price processes and analyze the problem of maximizing the expected utility of terminal wealth, for logarithmic and power utilities. We obtain and justify an extra no-arbitrage condition on the market parameters with which one obtains decomposition results for the optimal pairs-trading portfolio strategies.