Return and risk of pairs trading using a simulation-based Bayesian procedure for predicting stable ratios of stock prices
David Ardia, Lukasz T. Gatarek, Lennart Hoogerheide & Herman Van Dijk
| Résumé |
We investigate the direct connection between the uncertainty related
to estimated stable ratios of stock prices and risk and return of
two pairs trading strategies: a conditional statistical arbitrage
method and an implicit arbitrage one. A simulation-based Bayesian
procedure is introduced for predicting stable stock price ratios,
defined in a cointegration model. Using this class of models and
the proposed inferential technique, we are able to connect
estimation and model uncertainty with risk and return of stock
trading. In terms of methodology, we show the effect that using an
encompassing prior, which is shown to be equivalent to a Jeffreys’
prior, has under an orthogonal normalization for the selection of
pairs of cointegrated stock prices and further, its effect for the
estimation and prediction of the spread between cointegrated stock
prices. We distinguish between models with a normal and Student t
distribution since the latter typically provides a better
description of daily changes of prices on financial markets. As an
empirical application, stocks are used that are ingredients of the
Dow Jones Composite Average index. The results show that
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. |
| Mots-clés |
Bayesian analysis; cointegration; linear normalization; orthogonal normalization; pairs trading; statistical arbitrage |
| Citation | Ardia, D., Gatarek, L. T., Hoogerheide, L., & Van Dijk , H. (2016). Return and risk of pairs trading using a simulation-based Bayesian procedure for predicting stable ratios of stock prices. Econometrics, 4(1), 1-19. |
| Type | Article de périodique (Anglais) |
| Date de publication | 2016 |
| Nom du périodique | Econometrics |
| Volume | 4 |
| Numéro | 1 |
| Pages | 1-19 |
| URL | http://www.mdpi.com/2225-1146/4/1/14 |