Cointegration and Relative Value Arbitrage

44 Pages Posted: 22 Aug 2016 Last revised: 21 Sep 2016

See all articles by Binh Huu Do

Binh Huu Do

Monash University; Financial Research Network (FIRN)

Robert W. Faff

University of Queensland

Multiple version iconThere are 2 versions of this paper

Date Written: September 21, 2016

Abstract

We examine a new method for identifying close economic substitutes in the context of relative value arbitrage. We show that close economic substitutes correspond to a special case of cointegration whereby individual prices have approximately the same exposure to a common nonstationary factor. A metric of closeness constructed from the cointegrating relation strongly predicts both convergence probability and profitability in cointegration-based pairs trading. From 1962 to 2013, a strategy of trading cointegrated pairs of near-parity generates 58 bps per month after trading costs, experiences a 71% convergence probability and outperforms a strategy of pairs selected by minimized price distances.

Keywords: Relative Value Arbitrage, Convergence Trading, Statistical Arbitrage, Pairs Trading, Cointegration, Law of One Price

JEL Classification: G11, G12, G14

Suggested Citation

Do, Binh Huu and Faff, Robert W., Cointegration and Relative Value Arbitrage (September 21, 2016). 29th Australasian Finance and Banking Conference 2016. Available at SSRN: https://ssrn.com/abstract=2826190 or http://dx.doi.org/10.2139/ssrn.2826190

Binh Huu Do (Contact Author)

Monash University ( email )

Building 11E
Clayton, Victoria 3800
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Robert W. Faff

University of Queensland ( email )

St Lucia
Brisbane, Queensland 4072
Australia

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