Cointegration and Relative Value Arbitrage
44 Pages Posted: 22 Aug 2016 Last revised: 21 Sep 2016
Date Written: September 21, 2016
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
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