Pair Trading

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  • Topic: Short, Long, Stock
  • Pages : 15 (4624 words )
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  • Published : October 18, 2008
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CONTENTS
ACKNOWLEDGEMENT …………………………..............................................1 EXECUTIVE SUMMARY ………………………………………………………………..2 PAIRS TRADING: INTRODUCTION……………………………………………………..3 KEY CHARACTERISTICS………………………………………………………………….5 INSTRUMENTS USED FOR PAIRS TRADING ………………………………………...8 STRATEGY …………………………………………………………………………………10 TESTING FOR MEAN REVERSION ……………………………………………………10 PAIRS TRADING MODEL ………………………………………………………………..11 a.Screening for Pairs

b.Trading Rules
c.Risk Management
d.Risk involved
STEPS IN PAIR TRADING ……………………………………………………………….14 CASES ……………………………………………………………………………………….15 a.Bank of Baroda –Bank of India Pair
b.Infosys—TCS Pair
c.APIL—CESC Pair
CONCLUSION …………………………………………………………………………..22 BIBLIOGRAPHY …………………………………………………………………………23 ACKNOWLEDGEMENT

I take immense pleasure in submitting the project on “PAIR TRADING AND CONVERGENGE ARBITRAGE” This project has helped me
understand the intricacies involved in pair trading.

Firstly I would like to thank Prof.Navin Bhatia for giving me an Opportunity to work with him. I would like to acknowledge with special thanks the help of Dr. Poornima Dubey for helping in compiling and completion of the project and express my earnest gratitude towards her and for the inputs provided by her which helped me in successfully completing the project.

I also thank Prof. P.L Arya for giving me an opportunity to undertake this project. Finally I must express my heartiest gratitude toward all those who helped me directly or indirectly in the completion of this project.

EXECUTIVE SUMMARY

For the purpose of my summer internship which is a part of our curriculum in MMS, I got an opportunity to be a part of a prestigious project with Prof Naveen Bhatia. The project helped me in understanding the mechanics of convergence arbitrage and exposed me to the market parameters that can be taken as useful measures for creating and executing pairs.

It also introduced to me strategies like risk management in convergence trading and understand the importance and implications of such strategies as market neutral strategies.It provided me a rare opportunity to understand importance of various statistical tools in the world of investments. strategies like pair trading explore the temporary mispricing between assets and develops a framework to take advantage of this temporary mispricing. Market provides opportunities and it is individuals who should look at this opportunities in correct perspective. Pairs trading is useful in markets full of uncertainity.

PAIRS TRADING
INTRODUCTION
Pairs trading refers to opposite positions in two different stocks or indices, that is, a long (bullish) position in one stock and another short (bearish) position in another stock. The objective is to make money on the relative price movements between them. The two stocks might both go up, but the stock you are long will go up more and faster than the stock you are short. Or, the two stocks might both go down, but the stock you are short will drop more and faster than the stock you are long. One half of the pairs trade may be profitable, and the other half of the pairs trade may lose money, but the goal is for the profits to exceed the losses. The investment strategy we aim at implementing is a market neutral long/short strategy.

This implies that we will try to find shares with similar betas, where we believe one stock will outperform the other one in the short term. By simultaneously taking both a long and short position the beta of the pair equals zero and the performance generated equals alpha.

Pair of stock prices that have historically moved together in a correlated manner, diverge when subjected to differential demand shocks. position on such a pair when its components diverge and unwinding the position when they next converge has existed since the early periods of stock trading. The starting point of...
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