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M of a kind: A Multivariate Approach at Pairs Trading

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  • Perlin, M.

Abstract

Pairs trading is a popular trading strategy that tries to take advantage of market inefficiencies in order to obtain profit. Such approach, on its classical formulation, uses information of only two stocks (a stock and its pairs) in the formation of the trading signals. The objective of this paper is to suggest a multivariate version of pairs trading, which will try to create an artificial pair for a particular stock based on the information of m assets, instead of just one. The performance of three different versions of the multivariate approach was assessed for the Brazilian financial market using daily data from 2000 to 2006 for 57 assets. Considering realistic transaction costs, the analysis of performance was conducted with the calculation of raw and excessive returns, beta and alpha calculation, and the use of bootstrap methods for comparing performance indicators against portfolios build with random trading signals. The main conclusion of the paper is that the proposed version was able to beat the benchmark returns and random portfolios for the majority of the parameters. The performance is also found superior to the classic version of the strategy, Perlin (2006b). Another information derived from the research is that the proposed strategy picks up volatility from the data, that is, the annualized standard deviations of the returns are quite high. But, such event is “paid” by high positive returns at the long and short positions. This result is also supported by the positive annualized sharpe ratios presented by the strategy. Regarding systematic risk, the results showed that the proposed strategy does have a statistically significant beta, but it isn’t high in value, meaning that the relationship between return and risk for the trading rules is still attractive.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 8309.

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Date of creation: 01 Dec 2007
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Handle: RePEc:pra:mprapa:8309

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Keywords: pairs trading; asset allocation; quantitative strategy;

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References

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  1. Elroy Dimson & Massoud Mussavian, 1998. "A brief history of market efficiency," European Financial Management, European Financial Management Association, European Financial Management Association, vol. 4(1), pages 91-103.
  2. Michael Dueker & Christopher J. Neely, 2006. "Can Markov switching models predict excess foreign exchange returns?," Working Papers, Federal Reserve Bank of St. Louis 2001-021, Federal Reserve Bank of St. Louis.
  3. Evan G. Galev & William N. Goetzmann & K. Geert Rouwenhorst, 1999. "Pairs Trading: Performance of a Relative Value Arbitrage Rule," NBER Working Papers 7032, National Bureau of Economic Research, Inc.
  4. Park, Cheol-Ho & Irwin, Scott H., 2004. "The Profitability of Technical Analysis: A Review," AgMAS Project Research Reports, University of Illinois at Urbana-Champaign, Department of Agricultural and Consumer Economics 37487, University of Illinois at Urbana-Champaign, Department of Agricultural and Consumer Economics.
  5. Fernando Fernandez-Rodriguez & Simon Sosvilla-Rivero & Maria Dolores Garcia-Artiles, 1997. "Using nearest neighbour predictors to forecast the Spanish stock market," Investigaciones Economicas, Fundación SEPI, Fundación SEPI, vol. 21(1), pages 75-91, January.
  6. Perlin, M., 2007. "Evaluation of pairs trading strategy at the Brazilian financial market," MPRA Paper 8308, University Library of Munich, Germany.
  7. S. Illeris & G. Akehurst, 2001. "Introduction," The Service Industries Journal, Taylor & Francis Journals, Taylor & Francis Journals, vol. 21(1), pages 1-4, January.
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Cited by:
  1. Bolgun, Evren & Kurun, Engin & Guven, Serhat, 2009. "Dynamic Pairs Trading Strategy For The Companies Listed In The Istanbul Stock Exchange," MPRA Paper 19887, University Library of Munich, Germany.

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