Quantitative Arbitrage Trading Strategy Analysis

1731 Words Oct 7th, 2015 7 Pages
Many financial instruments have exhibited mean reversion, such as US and global equities [1], commodities [2], foreign exchange rates [3] as well as volatility indices [19]. Moreover, some researchers have also found mean reverting process to be very useful in modeling the interest rate and default risk dynamics [20]. In financial industry, some practitioners even attempt to profit by constructing mean-reverting prices which are usually known as statistical arbitrage or pair trading. Statistical arbitrage is a more sophisticated trading strategy that evolved out of the simpler pairs trade strategy [4]. In the pairs trading, two highly correlated stocks are put into pairs and when one stock outperforms the other, we short this stock and long the other stock. Unlike the pair trading, Statistical arbitrage usually considers a basket of hundreds or more stocks, long in some and short in others, in order to construct a mean reversion portfolio.

The pairs/statistical arbitrage trading strategies have gained great popularity with the invention of exchange-traded funds (ETFs), as some ETFs are created to track the underlying indexes/assets. The mean-reverting spreads among commodity ETFs have already been investigated and the trading strategies have been developed for statistical arbitrage [21]. Moreover, the mean-reverting spread between physical gold price and gold ETFs has also been investigated [22].

Given the dynamics of the underlying portfolio or assets, investors have to…
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