Systematic risk in pairs trading and dynamic parameterization

Yiyun Li and Keith K.F. Law

Economics Letters, 2021, vol. 202, issue C

Abstract: In statistical arbitrage, pairs trading is usually considered a risk-neutral strategy. However, the methodologies in existing literature on choosing thresholds and calibrating cointegration coefficients could be arbitrary and insensitive to market changes. This research discovers that static parameterization in pairs trading could result in undesirable systematic risk and potential losses. We apply Kalman Filter to intertemporally estimate cointegration coefficients and the absolute standardized residual (ASR) threshold, and relate the ADF-threshold with stochastic discount factors. Backtests confirm our superiority in attaining better risk-to-reward ratios and lower systematic risk.

Keywords: Pairs trading; Systematic risk; Cointegration; Kalman filter; Dynamic threshold (search for similar items in EconPapers)
JEL-codes: C51 C53 C58 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecolet:v:202:y:2021:i:c:s0165176521001191

DOI: 10.1016/j.econlet.2021.109842

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