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Cointegrated market-neutral strategy for basket trading

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  • Yu, Philip L.H.
  • Lu, Renjie

Abstract

Cointegration among two or more variables can be found in many economic or financial data. A typical application is to form portfolios based on the cointegrated relationships found in a set of financial assets in an attempt to generate profits. However, some high-net worth investors may find these portfolios too risky, particularly during a bear market, and hence they lose interest in adopting them in their trading strategies. A plausible method to relieve such burden to the investors is to construct a cointegrated portfolio which is also market-neutral. We name such cointegrated market-neutral portfolio as COINMAN. In this paper, we will tackle the problem of identifying COINMAN. We will discuss how to determine the number of COINMAN portfolios available among a set of assets. Finally, we apply the proposed methodology to identify COINMAN portfolios consisting of the constituent stocks of Hang Seng Index and Hang Seng China-Affiliated Corporations Index in Hong Kong. Our empirical results demonstrate that the trading strategies based on COINMAN portfolios are more profitable and less sensitive to the market than their cointegrated counterparts.

Suggested Citation

  • 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.
    • Handle: RePEc:eee:reveco:v:49:y:2017:i:c:p:112-124
    DOI: 10.1016/j.iref.2017.01.007
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    Cited by:

    1. 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.
    2. Renjie Lu & Philip L.H. Yu & Xiaohang Wang, 2020. "Sparse vector error correction models with application to cointegration‐based trading," Australian & New Zealand Journal of Statistics, Australian Statistical Publishing Association Inc., vol. 62(3), pages 297-321, September.

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    More about this item

    Keywords

    Basket trading; Pairs trading; Cointegration; Market neutral; C22; G12;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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