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Pairs Trading: Quantitative Methods and Analysis

Book Description

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.

Ganapathy Vidyamurthy (Stamford, CT) is currently a quantitative software analyst and developer at a major New York City hedge fund.

Table of Contents

  1. Title Page
  2. Copyright Page
  3. Preface
  4. Acknowledgments
  5. PART One - Background Material
    1. CHAPTER 1 - Introduction
      1. THE CAPM MODEL
      2. MARKET NEUTRAL STRATEGY
      3. PAIRS TRADING
      4. OUTLINE
      5. AUDIENCE
      6. SUMMARY
      7. FURTHER READING MATERIAL
      8. APPENDIX
      9. DEFINITIONS
      10. FORMULAS
    2. CHAPTER 2 - Time Series
      1. OVERVIEW
      2. AUTOCORRELATION
      3. TIME SERIES MODELS
      4. FORECASTING
      5. GOODNESS OF FIT VERSUS BIAS
      6. MODEL CHOICE
      7. MODELING STOCK PRICES
      8. SUMMARY
      9. FURTHER READING MATERIAL
      10. APPENDIX
    3. CHAPTER 3 - Factor Models
      1. INTRODUCTION
      2. ARBITRAGE PRICING THEORY
      3. THE COVARIANCE MATRIX
      4. APPLICATION: CALCULATING THE RISK ON A PORTFOLIO
      5. APPLICATION: CALCULATION OF PORTFOLIO BETA
      6. APPLICATION: TRACKING BASKET DESIGN
      7. SENSITIVITY ANALYSIS
      8. SUMMARY
      9. FURTHER READING MATERIAL
    4. CHAPTER 4 - Kalman Filtering
      1. INTRODUCTION
      2. THE KALMAN FILTER
      3. THE SCALAR KALMAN FILTER
      4. FILTERING THE RANDOM WALK
      5. APPLICATION: EXAMPLE WITH THE STANDARD & POOR INDEX
      6. SUMMARY
      7. FURTHER READING MATERIAL
      8. APPENDIX
  6. PART Two - Statistical Arbitrage Pairs
    1. CHAPTER 5 - Overview
      1. HISTORY
      2. MOTIVATION
      3. COINTEGRATION
      4. APPLYING THE MODEL
      5. A TRADING STRATEGY
      6. ROAD MAP FOR STRATEGY DESIGN
      7. SUMMARY
      8. FURTHER READING MATERIAL
    2. CHAPTER 6 - Pairs Selection in Equity Markets
      1. INTRODUCTION
      2. COMMON TRENDS COINTEGRATION MODEL
      3. COMMON TRENDS MODEL AND APT
      4. THE DISTANCE MEASURE
      5. INTERPRETING THE DISTANCE MEASURE
      6. RECONCILING THEORY AND PRACTICE
      7. SUMMARY
      8. FURTHER READING MATERIAL
      9. APPENDIX: EIGENVALUE DECOMPOSITION
    3. CHAPTER 7 - Testing For Tradability
      1. INTRODUCTION
      2. THE LINEAR RELATIONSHIP
      3. ESTIMATING THE LINEAR RELATIONSHIP: THE MULTIFACTOR APPROACH
      4. ESTIMATING THE LINEAR RELATIONSHIP: THE REGRESSION APPROACH
      5. TESTING RESIDUAL FOR TRADABILITY
      6. SUMMARY
      7. FURTHER READING MATERIAL
    4. CHAPTER 8 - Trading Design
      1. INTRODUCTION
      2. BAND DESIGN FOR WHITE NOISE
      3. SPREAD DYNAMICS
      4. NONPARAMETRIC APPROACH
      5. REGULARIZATION
      6. TYING UP LOOSE ENDS
      7. SUMMARY
      8. FURTHER READING MATERIAL
  7. PART Three - Risk Arbitrage Pairs
    1. CHAPTER 9 - Risk Arbitrage Mechanics
      1. INTRODUCTION
      2. HISTORY
      3. THE DEAL PROCESS
      4. TRANSACTION TERMS
      5. THE DEAL SPREAD
      6. TRADING STRATEGY
      7. QUANTITATIVE ASPECTS
      8. SUMMARY
      9. FURTHER READING MATERIAL
    2. CHAPTER 10 - Trade Execution
      1. INTRODUCTION
      2. SPECIFYING THE ORDER
      3. VERIFYING THE EXECUTION
      4. EXECUTION DURING THE PRICING PERIOD
      5. SHORT SELLING
      6. SUMMARY
      7. FURTHER READING MATERIAL
      8. APPENDIX - DINIC’S ALGORITHM FOR MAXIMUM FLOW IN A NETWORK
      9. LAZY ALLOCATION ALGORITHM
    3. CHAPTER 11 - The Market Implied Merger Probability
      1. INTRODUCTION
      2. IMPLIED PROBABILITIES AND ARROW-DEBREU THEORY
      3. THE SINGLE-STEP MODEL
      4. THE MULTISTEP MODEL
      5. RECONCILING THEORY AND PRACTICE
      6. RISK MANAGEMENT
      7. SUMMARY
      8. FURTHER READING MATERIAL
      9. APPENDIX
    4. CHAPTER 12 - Spread Inversion
      1. INTRODUCTION
      2. THE PREDICTION EQUATION
      3. THE OBSERVATION EQUATION
      4. APPLYING THE KALMAN FILTER
      5. MODEL SELECTION
      6. APPLICATIONS TO TRADING
      7. SUMMARY
      8. FURTHER READING MATERIAL
      9. APPENDIX
  8. Index