Selection of a Portfolio of Pairs Based on Cointegration: A Statistical Arbitrage Strategy

• Main Authors: João Frois Caldeira, Gulherme Valle Moura
• Format: Article
• Language: English
• Published: Brazilian Society of Finance 2013-03-01
• Series: Revista Brasileira de Finanças
• Subjects: statistical arbitrage; pairs trading; cointegration; market neutral strategy
• Online Access: http://bibliotecadigital.fgv.br/ojs/index.php/rbfin/article/view/4785/7889

Statistical arbitrage strategies, such as pairs trading and its generalizations, rely on the construction of mean- reverting spreads with a certain degree of predictability. This paper applies cointegration tests to identify stocks to be used in pairs trading strategies. In addition to estimating long-term equilibrium and to model the resulting residuals, we select stock pairs to compose a pairs trading portfolio based on an indicator of profitability evaluated in-sample. The profitability of the strategy is assessed with data from the São Paulo stock exchange ranging from January 2005 to October 2012. Empirical analysis shows that the proposed strategy exhibit excess returns of 16.38% per year, Sharpe Ratio of 1.34 and low correlation with the market.