Pairs Trading with Copulas

Posted: 23 Jan 2014

See all articles by Wenjun Xie

Wenjun Xie

Nanyang Technological University (NTU) - Division of Banking & Finance

Qi Rong Liew

Nanyang Technological University (NTU)

Yuan Wu

Nanyang Technological University (NTU) - Division of Banking & Finance

Xi Zou

Nanyang Technological University (NTU)

Date Written: January 22, 2014

Abstract

Pairs trading is a well-acknowledged speculative investment strategy that is widely used in the financial markets, and distance method is the most commonly implemented pairs trading strategy by traders and hedge funds. However, this approach, which can be seen as a standard linear correlation analysis, is only able to fully describe the dependency structure between stocks under the assumption of multivariate normal returns. To overcome this limitation, we propose a new pairs trading strategy using copula modeling technique. Copula allows separate estimation of the marginal distributions of stock returns as well as their joint dependency structure. Thus, the proposed new strategy, which is based on the estimated optimal dependency structure and marginal distributions, can identify relative undervalued or overvalued positions with more accuracy and confidence. Hence, it is deemed to generate more trading opportunities and profits. A simple one-pair-one-cycle example is used to illustrate the advantages of the proposed method. Besides, a large sample analysis using the utility industry data is provided as well. The overall empirical results have verified that the proposed strategy can generate higher profits compared with the conventional distance method. We argue that the proposed trading strategy can be considered as a generalization of the conventional pairs trading strategy.

Keywords: Pairs Trading, Copulas, Dependency Structure, Correlation

JEL Classification: G10, G11, G12

Suggested Citation

Xie, Wenjun and Liew, Qi Rong and Wu, Yuan and Zou, Xi, Pairs Trading with Copulas (January 22, 2014). Available at SSRN: https://ssrn.com/abstract=2383185 or http://dx.doi.org/10.2139/ssrn.2383185

Wenjun Xie (Contact Author)

Nanyang Technological University (NTU) - Division of Banking & Finance ( email )

S3-B1B-76 Nanyang Avenue
Singapore, 639798
Singapore

Qi Rong Liew

Nanyang Technological University (NTU) ( email )

S3 B2-A28 Nanyang Avenue
Singapore, 639798
Singapore

Yuan Wu

Nanyang Technological University (NTU) - Division of Banking & Finance ( email )

S3-B1B-76 Nanyang Avenue
Singapore, 639798
Singapore

Xi Zou

Nanyang Technological University (NTU) ( email )

S3 B2-A28 Nanyang Avenue
Singapore, 639798
Singapore

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