Pairs Trading And Strategies And The CAPM Dissertation

Pairs Trading And Strategies And The CAPM - Dissertation Example Besides testing a model, this study will also be testing market efficiency and using use Cointegration as a decision rule for pair selection, try to ascertain whether different and more efficient rules may be implemented. In order to calculate asset returns we need the Capital Asset Pricing Model (CAPM) which gives predictions on how to measure risk and the relationship between risk and return. The relationship of expected return is linear and is necessary to explain differences in returns among securities. Introduction Pairs trading include tested methods used to identify and invest in pairs. This was developed by Morgan Stanley in the 1980’s and is today one of the most commonly used strategies in the finance and trading industry. Using this strategy, an investor looks at two assets, whose prices have moved together in the past. As the price spread widens, the investor takes a short position in the outperforming asset and a long position in the underperforming asset hoping t hat the spread will move back again, thereby generating profits. If history then repeats itself, prices will congregate and the arbitrageur will earn revenue. For example, if the U.S. equity markets were efficient at all times, risk-adjusted returns from pairs trading would never be positive. The Morgan Stanley group disbanded in 1989 after a couple of bad years of performance, pairs trading has since then become an progressively more well known market-neutral investment strategy used by investors as well as hedge funds. The increased popularity of quantitative based statistical arbitrage strategies has also been affecting the profits. The Capital Asset Pricing Model (CAPM) is a vital area of financial management that has contributed to finance becoming a scientific and fully fledged discipline of study. There abounds criticism that the Capital Asset Pricing Model is somewhat unrealistic due to the assumptions that it is based upon. This includes the assumption that investors would only require returns on the systematic risking of their portfolios, due to the removal of the unsystematic risk which can hence be ignored. The market neutral portfolios are constructed using just two securities, consisting of a long position in one and a short position in the other, in a predetermined ratio. The two versions of pairs trading in the equity markets are statistical arbitrage pairs and risk arbitrage pairs. A Statistical arbitrage pair trading is based on the idea of relative pricing. The underlying premise in relative pricing is that stocks with similar characteristics must be priced more or less the same. The spread in the case may be thought of as a degree of mutual mispricing, so the greater the spread, the higher the magnitude of mispricing and hence a greater scope of profit. The strategy involves assuming a long-short position when the spread is substantially away from the mean. It is expected that the mispricing will be correct. The position is then reversed an d profits are made when the spread reverts. The pairs trading strategy might be justified within an equilibrium asset-pricing framework with non-stationary common factors as noted in Fund & Hsieh (1999). Asset returns can be computed by Capital Asset Pri