Pairs trading
Date
2005
Authors
Elliott, Robert J
Van der Hoek, J
Malcolm, William
Journal Title
Journal ISSN
Volume Title
Publisher
Institute of Physics Publishing
Abstract
'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 compared with subsequent observations of the spread to determine appropriate investment decisions. The methodology has potential applications to generating wealth from any quantities in financial markets which are observed to be out of equilibrium.
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Keywords
Keywords: Hedge funds; Pairs trading; Spreads
Citation
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Source
Quantitative Finance
Type
Journal article
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Restricted until
2037-12-31
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