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Pairs trading: The performance of a stochastic spread model with regime switching-evidence from the S&P 500

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  • Yang, Jen-Wei
  • Tsai, Shu-Yu
  • Shyu, So-De
  • Chang, Chia-Chien

Abstract

There remains a lack of literature on a pairs-trading model that is able to capture the mean reversion and two different states of spreads. The purpose of this study is to combine the Markov regime-switching model and the Vasicek model to implement a pairs-trading strategy that utilizes the S&P 500 stock components from January 1, 2006, through September 28, 2012. We compare our model's performance with the performance of previous methods based on a variety of portfolios and trading periods. The empirical results show that the trading rule of the Markov regime-switching model with mean reversion has the best performance with a simple portfolio. Furthermore, the results show that shorter trading periods produce better performance than longer trading periods and that the trading rule performs strongly during the global financial crisis of 2008 to 2009.

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  • Yang, Jen-Wei & Tsai, Shu-Yu & Shyu, So-De & Chang, Chia-Chien, 2016. "Pairs trading: The performance of a stochastic spread model with regime switching-evidence from the S&P 500," International Review of Economics & Finance, Elsevier, vol. 43(C), pages 139-150.
    • Handle: RePEc:eee:reveco:v:43:y:2016:i:c:p:139-150
    DOI: 10.1016/j.iref.2015.10.036
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    Cited by:

    1. Zhao-Hua Lu & Sy-Miin Chow & Nilam Ram & Pamela M. Cole, 2019. "Zero-Inflated Regime-Switching Stochastic Differential Equation Models for Highly Unbalanced Multivariate, Multi-Subject Time-Series Data," Psychometrika, Springer;The Psychometric Society, vol. 84(2), pages 611-645, June.
    2. Yu, Philip L.H. & Lu, Renjie, 2017. "Cointegrated market-neutral strategy for basket trading," International Review of Economics & Finance, Elsevier, vol. 49(C), pages 112-124.
    3. Weiliang Lu & Alexis Arrigoni & Anatoliy Swishchuk & Stéphane Goutte, 2021. "Modelling of Fuel- and Energy-Switching Prices by Mean-Reverting Processes and Their Applications to Alberta Energy Markets," Mathematics, MDPI, vol. 9(7), pages 1-24, March.
    4. Wang, Jai-Jen & Lee, Jin-Ping & Zhao, Yang, 2018. "Pair-trading profitability and short-selling restriction: Evidence from the Taiwan stock market," International Review of Economics & Finance, Elsevier, vol. 55(C), pages 173-184.
    5. Nikolaos Limnios & Anatoliy Swishchuk, 2020. "Discrete-Time Semi-Markov Random Evolutions in Asymptotic Reduced Random Media with Applications," Mathematics, MDPI, vol. 8(6), pages 1-16, June.
    6. Zhe Huang & Franck Martin, 2017. "Optimal pairs trading strategies in a cointegration framework," Economics Working Paper Archive (University of Rennes & University of Caen) 2017-08, Center for Research in Economics and Management (CREM), University of Rennes, University of Caen and CNRS.
    7. Endres, Sylvia & Stübinger, Johannes, 2018. "A flexible regime switching model with pairs trading application to the S&P 500 high-frequency stock returns," FAU Discussion Papers in Economics 07/2018, Friedrich-Alexander University Erlangen-Nuremberg, Institute for Economics.
    8. Fernando Caneo & Werner Kristjanpoller, 2021. "Improving statistical arbitrage investment strategy: Evidence from Latin American stock markets," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(3), pages 4424-4440, July.

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