Pairs trading: a copula approach

Augustine, Cecilia

Pairs trading: a copula approach

Master Thesis

2014

Publisher

University of Cape Town

Department

Division of Actuarial Science

Faculty

Faculty of Commerce

Abstract

Pairs trading is an arbitrage strategy that involves identifying a pair of stocks known to move together historically and trading on them when relative mispricing occurs. The strategy involves shorting the overvalued stock and simultaneously going long on the undervalued stock and closing the positions once the prices have returned to fair values. The cointegration method and the distance method are the most common techniques used in pairs trading strategy. However under these methods, the measure of divergence between the stocks or the spread is assumed to be symmetrically distributed about the mean zero. In addition, the spread is assumed to be a stationary time series (cointegration method) or mean-reverting (distance method). These assumptions are the main drawbacks of these methods and may lead to missed and/or inaccurate trading signals. The purpose of this dissertation is to explore an alternative approach to pairs trading by use of copulas. This dissertation aims to investigate if copulas can improve the profitability of pairs trading. To achieve this aim, results of pairs trading by use of copulas are compared against those of cointegration and distance methods.

Description

Includes bibliographical references.

Keywords

Mathematical Finance

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