Pairs Trading

Quantitative Methods and Analysis

By: Ganapathy Vidyamurthy

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Product code: 20709
ISBN: 0471460672
210 pages
Format: Hb
Published by: John Wiley & Sons, 2004, 1st edition

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Description of Pairs Trading

The first in-depth analysis of pairs trading

Pairs trading is a market-neutral strategy in its most simple form. The strategy involves being long (or bullish) one asset and short (or bearish) another. If properly performed, the investor will gain if the market rises or falls. Pairs Trading reveals the secrets of this rigorous quantitative analysis program to provide individuals and investment houses with the tools they need to successfully implement and profit from this proven trading methodology.

Pairs Trading contains specific and tested formulas for identifying and investing in pairs, and answers important questions such as what ratio should be used to construct the pairs properly.

Pairs Trading - Chapter headings

Preface
Acknowledgments

PART ONE: Background Material

1. Introduction
The CAPM Model
Market Neutral Strategy
Pairs Trading
Outline
Audience

2. Time Series
Overview
Autocorrelation
Time Series Models
Forecasting
Goodness of Fit versus Bias
Model Choice
Modeling Stock Prices

3. Factor Models
Introduction
Arbitrage Pricing Theory
The Covariance Matrix
Application: Calculating the Risk on a Portfolio
Application: Calculation of Portfolio Beta
Application: Tracking Basket Design
Sensitivity Analysis

4. Kalman Filtering
Introduction
The Kalman Filter
The Scalar Kalman Filter
Filtering the Random Walk
Application: Example with the Standard & Poor Index

PART TWO: Statistical Arbitrage Pairs

5. Overview
History
Motivation
Cointegration
Applying the Model
A Trading Strategy
Road Map for Strategy Design

6. Pairs Selection in Equity Markets
Introduction
Common Trends Cointegration Model
Common Trends Model and APT
The Distance Measure
Interpreting the Distance Measure
Reconciling Theory and Practice

7. Testing for Tradability
Introduction
The Linear Relationship
Estimating the Linear Relationship: The Multifactor Approach
Estimating the Linear Relationship: The Regression Approach
Testing Residual for Tradability

8. Trading Design
Introduction
Band Design for White Noise
Spread Dynamics
Nonparametric Approach
Regularization
Tying Up Loose Ends

PART THREE: Risk Arbitrage Pairs

9. Risk Arbitrage Mechanics
Introduction
History
The Deal Process
Transaction Terms
The Deal Spread
Trading Strategy
Quantitative Aspects

10. Trade Execution
Introduction
Specifying the Order
Verifying the Execution
Execution During the Pricing Period
Short Selling

11. The Market Implied Merger Probability
Introduction
Implied Probabilities and Arrow-Debreu Theory
The Single-Step Model
The Multistep Model
Reconciling Theory and Practice
Risk Management

12. Spread Inversion
Introduction
The Prediction Equation
The Observation Equation
Applying the Kalman Filter
Model Selection
Applications to Trading

Index

Authobiography of Ganapathy Vidyamurthy

Ganapathy Vidyamurthy has been working in the financial markets for nearly a decade. During this time, he created the entire risk management software infrastructure for RBC Dominion Securities in New York, and built valuation models and automated execution strategies for UBS Warburg and JP Morgan Fleming. He is currently the principal of Himalaya Consulting.

Beyond finance, Mr. Vidyamurthy's interests range from discrete optimization to algorithmic music composition - a field in which he is often cited. Mr. Vidyamurthy has a master's degree in electrical communication engineering from the Indian Institute of Science and a master's degree from the Courant Institute of Mathematical Sciences of New York University.