Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/98882
Authors: 
Gatarek, Lukasz
Hoogerheide, Lennart
van Dijk, Herman K.
Year of Publication: 
2014
Series/Report no.: 
Tinbergen Institute Discussion Paper 14-039/III
Abstract: 
In this paper we consider two cases of pairs trading strategies: a conditional statistical arbitrage method and an implicit statistical arbitrage method. We use a simulation-based Bayesian procedure for predicting stable ratios, defined in a cointegration model, of pairs of stock prices. We show the effect that using an encompassing prior under an orthogonal normalization has for the selection of pairs of cointegrated stock prices and for the estimation and prediction of the spread between cointegrated stock prices and its uncertainty. An empirical application is done using stocks that are ingredients of the Dow Jones Composite Average index. The results show that the normalization has little effect on the selection of pairs of cointegrated stocks on the basis of Bayes factors. However, the results stress the importance of the orthogonal normalization for the estimation and prediction of the spread – the deviation from the equilibrium relationship – which leads to better results in terms of profit per capital engagement and risk than using a standard linear normalization
Subjects: 
Bayesian analysis
cointegration
linear normalization
orthogonal normalization
pairs trading
statistical arbitrage
JEL: 
C11
C15
C32
C58
G17
Document Type: 
Working Paper

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