A Regime-Switching Relative Value Arbitrage Rule

Summary The relative value arbitrage rule, also known as “pairs trading” or “statistical arbitrage”, is a well established speculative investment strategy on financial markets, dating back to the 1980s. Today, especially hedge funds and investment banks extensively implement pairs trading as a long/short investment strategy. Based on relative mispricing between a pair of stocks, pairs trading strategies create excess returns if the spread between two normally comoving stocks is away from its equilibrium path and is assumed to be mean reverting, i.e. deviations from the long term spread are only temporary effects. In this situation, pairs trading suggests to take a long position in the relative undervalued stock, while the relative overvalued stock should be shortened. The formation of the pairs ensues from a cointegration analysis of the historical prices. Consequently, pairs trading represents a form of statistical arbitrage where econometric time series models are applied to identify trading signals. However, fundamental economic reasons might cause simple pairs trading signals to be wrong. Think of a situation in which a profit warning of one of the two stocks entails the persistant widening of the spread, whereas for the other no new information is circulated. Under these circumstances, betting on the spread to revert to its historical mean would imply a loss.