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Pairs Trading: An Implementation of the Kalman Filter on the Swedish Equity Market

Bijelic, Anna LU and Lundholm, Jens (2018) NEKH02 20181
Department of Economics
Abstract
Pairs trading is a widely known investment strategy among hedge funds and institutional investors that focuses on profiting from the relative mispricing between assets. A vast majority of exisiting pairs trading algorithms rely on rather restrictive assumptions concerning the modeling of the so-called spread function and are unable to capture the effects of changing market conditions into the trading procedure. Hence, this study attempts to optimize the pairs trading strategy by applying a dynamic model that is able to update the parameters of the spread function continuously over time and thereby capture new information coming in from the market. This is accomplished by implementing a Kalman filter on the cointegration approach with data... (More)
Pairs trading is a widely known investment strategy among hedge funds and institutional investors that focuses on profiting from the relative mispricing between assets. A vast majority of exisiting pairs trading algorithms rely on rather restrictive assumptions concerning the modeling of the so-called spread function and are unable to capture the effects of changing market conditions into the trading procedure. Hence, this study attempts to optimize the pairs trading strategy by applying a dynamic model that is able to update the parameters of the spread function continuously over time and thereby capture new information coming in from the market. This is accomplished by implementing a Kalman filter on the cointegration approach with data from the Swedish equity market. The empirical results suggest that the implemented pairs trading strategy exhibits excess returns of 58.16 % and is superior to the traditional, static model in terms of both return and risk metrics. (Less)
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author
Bijelic, Anna LU and Lundholm, Jens
supervisor
organization
course
NEKH02 20181
year
type
M2 - Bachelor Degree
subject
keywords
Pairs trading, statistical arbitrage, Kalman filter, cointegration
language
English
id
8947454
date added to LUP
2018-07-05 11:24:47
date last changed
2018-07-05 11:24:47
@misc{8947454,
  abstract     = {Pairs trading is a widely known investment strategy among hedge funds and institutional investors that focuses on profiting from the relative mispricing between assets. A vast majority of exisiting pairs trading algorithms rely on rather restrictive assumptions concerning the modeling of the so-called spread function and are unable to capture the effects of changing market conditions into the trading procedure. Hence, this study attempts to optimize the pairs trading strategy by applying a dynamic model that is able to update the parameters of the spread function continuously over time and thereby capture new information coming in from the market. This is accomplished by implementing a Kalman filter on the cointegration approach with data from the Swedish equity market. The empirical results suggest that the implemented pairs trading strategy exhibits excess returns of 58.16 % and is superior to the traditional, static model in terms of both return and risk metrics.},
  author       = {Bijelic, Anna and Lundholm, Jens},
  keyword      = {Pairs trading,statistical arbitrage,Kalman filter,cointegration},
  language     = {eng},
  note         = {Student Paper},
  title        = {Pairs Trading: An Implementation of the Kalman Filter on the Swedish Equity Market},
  year         = {2018},
}