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Demonstrating error-correction modelling for intraday statistical arbitrage

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  • Brian Jacobsen

Abstract

Applying cointegration analysis to security price movements illustrates how securities move together in the long-term. This can be augmented with an error-correction model to show how the long-run relationship is approached when the security prices are out of line with their cointegrated relationship. Cointegration and error-correction modelling promises to be useful in statistical arbitrage applications: not only does it show what relative prices of securities should be, but it also illuminates the short-run dynamics of how equilibrium should be restored along with how long it will take. Cointegration, coupled with error-correction modelling, promises to be a profitable way of implementing statistical arbitrage strategies.1 Bondarenko (2003) and Hogan et al. (2004) defined statistical arbitrage as an attempt to exploit the long-horizon trading opportunities revealed by cointegration relationships. Alexander and Dimitriu (2005) showed how cointegration is a better way of implementing a statistical arbitrage strategy than other conventional ways, like the use of tracking error variance minimization. These previous studies, however, did not add error-correction modelling to the trading strategies. This article seeks to fill that gap, by presenting how to implement a statistical arbitrage strategy based on cointegration and error-correction modelling.

Suggested Citation

  • Brian Jacobsen, 2008. "Demonstrating error-correction modelling for intraday statistical arbitrage," Applied Financial Economics Letters, Taylor and Francis Journals, vol. 4(4), pages 287-292.
  • Handle: RePEc:taf:apfelt:v:4:y:2008:i:4:p:287-292
    DOI: 10.1080/17446540701720550
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    Cited by:

    1. Bredin, Don & Muckley, Cal, 2011. "An emerging equilibrium in the EU emissions trading scheme," Energy Economics, Elsevier, vol. 33(2), pages 353-362, March.
    2. Alexakis, Christos, 2010. "Long-run relations among equity indices under different market conditions: Implications on the implementation of statistical arbitrage strategies," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 20(4), pages 389-403, October.

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