Report on Trend following trading with mean reverting drift assets by Vu,

Ho and Duong
This paper studies an optimal switching problem with partial information. The log-asset price follows a
linear diffusion with a stochastic drift t which is an OU process. The aim of the agent is to maximize
expected rate of return over time by sequentially buying and selling the asset. The drift is assumed
to be unobserved, so the authors first apply Kalman filter to derive its posterior t|t and then derive
and discuss the resulting 2-D time-inhomogenous HJB equation. After verifying basic properties of the
value function (smoothness, monotonicity, time-derivative, verification theorem), the authors mention a
numerical penalty method to solve the system of two HJB equations. A small numerical example based
on a dataset of gold prices illustrates the solution.
The manuscript falls short of the standards of Finance & Stochastics on several counts:
1. The authors do not seem to be aware of the extensive literature related to multiple optimal stopping
and optimal switching that has already been applied to very similar problems (pairs trading, meanreverting assets). For example, the most well-cited paper in the area (Zhang & Zhang, Automatica
2008) is not mentioned, and neither are many other works by eg Zervos, Leung, Ekstrom, etc.
2. The mathematical proofs given are related to just stating the HJB equation and verifying that its
solution solves the control problem. These are standard tools and show no mathematical innovation.
3. The ultimate solution is via a finite-difference PDE penalty scheme, which is again a classical textbook method, without any methodological contribution. Consequently, mathematically/numerically
the paper reads like a case-study.
Lastly, the given empirical illustration is hard to follow. To apply the presented model, one must first
estimate model parameters and then trade accordingly. However, it seems that the authors did everything
on the same sample, ie use the full 2003-2011 dataset to both fit the parameters and to simultaneously
filter t|t . This would obviously severely bias the profitability of the strategy (and one can argue whether
such a simple price model would apply over a fairly long period of 8+ years).
There are also numerous issues with the English used, including grammatical typos, punctuation, incorrect use of terminology and confusing statements. Proofreading by a native English editor is necessary.
Further comments:
p1: The common terminology is state space model, not space-state
p1: what does quadratic numerical solving refer to? Speed of convergence?
p2: the authors claim that the cited regime switching models seem to be not general enough.
How does the proposed 2-factor OU model allow more flexibility? It is still fully specified and has
just a couple of parameters to calibrate. The only difference is a conceptual distinction whether
the drift process is continuous or not in time.
What is 0 in eqn (3.3)?
The equation below (3.3) is not exact, but an approximation based on Euler scheme (the true Xt+1
involves a time integral of t ), so that (3.4) is not formally correct [not that it matters much for
the subsequent analysis].
There is a conceptual issue of obtaining a time inhomogenous solution for a stationary model. The
time-dependence only comes from the non-constant posterior variance of the estimated drift, but
that also converges rather quickly and moreover its not clear why a participant would be more
uncertain about t t time zero compared to time t > 0 (supposedly participants are long-lived).
p12: there is no explanation what do the buy-and-hold and SMA strategies entail in this context,
so its impossible to judge Table 6.1. Also Fig 6.5 is rather redundant.
There is duplication between references 18 and 19