Pairs Trading: Quantitative Methods and Analysis

1

The assertion of CAPM that the expected value of residual return is zero is rather strong. It has been discussed extensively in academic literature as to whether this prediction of CAPM is indeed observable. It is therefore recommended that we explicitly verify the mean-reverting behavior of the spread time series. In later chapters we will discuss methods to statistically check for mean-reverting behavior.

2

Nobert Weiner is also credited with coining the word cybernetics, the shortened version of which is the ubiquitous cyber, which has by usage become a prefix for a lot of terms associated with the Internet.

3

Beta in this connotation is a nondescript Greek symbol denoting a constant and has no relationship to the CAPM model.

4

We touch upon this topic very briefly in the appendix. However, for a full-blown discussion on stability analysis, we recommend that the reader follow up with the references.

5

Eviews, S-Plus, and SAS are some software packages that deal with time series modeling and forecasting.

6

AIC is but one of many cost functions. The Schwartz information criterion (SIC) and the Bayesian information criterion (BIC) are also popular.

7

. Hence the difference in the logarithm may be construed to be the return.

8

Kalman, R. E. ( 1960). “A New Approach to Filtering and Prediction Problems.” Transaction of the ASME Journal of Basic Engineering, 82(Series D), 35-45. ...