Systematic risk in pairs trading and dynamic parameterization

摘要

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. (c) 2021 Elsevier B.V. All rights reserved.