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Systematic risk in pairs trading and dynamic parameterization

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  • Li, Yiyun
  • Law, Keith K.F.

Abstract

In statistical arbitrage, pairs trading is usually considered a risk-neutral strategy. However, the methodologies in existing literature on choosing thresholds and calibrating cointegration coefficients could be arbitrary and insensitive to market changes. This research discovers that static parameterization in pairs trading could result in undesirable systematic risk and potential losses. We apply Kalman Filter to intertemporally estimate cointegration coefficients and the absolute standardized residual (ASR) threshold, and relate the ADF-threshold with stochastic discount factors. Backtests confirm our superiority in attaining better risk-to-reward ratios and lower systematic risk.

Suggested Citation

  • Li, Yiyun & Law, Keith K.F., 2021. "Systematic risk in pairs trading and dynamic parameterization," Economics Letters, Elsevier, vol. 202(C).
    • Handle: RePEc:eee:ecolet:v:202:y:2021:i:c:s0165176521001191
    DOI: 10.1016/j.econlet.2021.109842
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    References listed on IDEAS

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    1. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    2. Evan Gatev & William N. Goetzmann & K. Geert Rouwenhorst, 2006. "Pairs Trading: Performance of a Relative-Value Arbitrage Rule," The Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 797-827.
    3. Law, K.F. & Li, W.K. & Yu, Philip L.H., 2018. "A single-stage approach for cointegration-based pairs trading," Finance Research Letters, Elsevier, vol. 26(C), pages 177-184.
    4. João Frois Caldeira & Gulherme Valle Moura, 2013. "Selection of a Portfolio of Pairs Based on Cointegration: A Statistical Arbitrage Strategy," Brazilian Review of Finance, Brazilian Society of Finance, vol. 11(1), pages 49-80.
    5. Christopher Krauss, 2017. "Statistical Arbitrage Pairs Trading Strategies: Review And Outlook," Journal of Economic Surveys, Wiley Blackwell, vol. 31(2), pages 513-545, April.
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    Cited by:

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    More about this item

    Keywords

    Pairs trading; Systematic risk; Cointegration; Kalman filter; Dynamic threshold;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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