Saturday, June 25, 2005

Funda of week: pairs trading

Excerpt from paper by Hong and Susmel, 2003:

Pairs-trading is an old portfolio management technique based on a classic hedge:
a manager looks at stocks in pairs, buying the one she expects to perform best and selling short the one she expects to underperform. The concept has been generalized to accommodate long and short portfolios with different performance expectations. In the 1980s, hedge funds popularized pairs-trading.

The pairs-trading strategy, also known as “statistical arbitrage” and loosely based on the “Law of One Price”, is very simple: find two stocks whose prices have moved together historically. When the spread between them widens, short the winner and buy the loser. If the joint distribution of the two stocks is stationary, prices will converge and the arbitrageur will profit.


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