'Pairs Trading' is an investment strategy used by many Hedge Funds. Consider two similar stocks which trade at some spread. If the spread widens short the high stock and buy the low stock. As the spread narrows again to some equilibrium value, a profit results. This paper provides an analytical framework for such an investment strategy. We propose a meanreverting Gaussian Markov chain model for the spread which is observed in Gaussian noise. Predictions from the calibrated model are then...[Show more]
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