Dynamic modeling of mean-reverting spreads for statistical arbitrage
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Publication:545522
DOI10.1007/S10287-009-0105-8zbMATH Open1214.91142arXiv0808.1710OpenAlexW2102084986MaRDI QIDQ545522FDOQ545522
Authors: Yong-Cai Geng, Sumit K. Garg 
Publication date: 22 June 2011
Published in: Computational Management Science (Search for Journal in Brave)
Abstract: Statistical arbitrage strategies, such as pairs trading and its generalizations, rely on the construction of mean-reverting spreads enjoying a certain degree of predictability. Gaussian linear state-space processes have recently been proposed as a model for such spreads under the assumption that the observed process is a noisy realization of some hidden states. Real-time estimation of the unobserved spread process can reveal temporary market inefficiencies which can then be exploited to generate excess returns. Building on previous work, we embrace the state-space framework for modeling spread processes and extend this methodology along three different directions. First, we introduce time-dependency in the model parameters, which allows for quick adaptation to changes in the data generating process. Second, we provide an on-line estimation algorithm that can be constantly run in real-time. Being computationally fast, the algorithm is particularly suitable for building aggressive trading strategies based on high-frequency data and may be used as a monitoring device for mean-reversion. Finally, our framework naturally provides informative uncertainty measures of all the estimated parameters. Experimental results based on Monte Carlo simulations and historical equity data are discussed, including a co-integration relationship involving two exchange-traded funds.
Full work available at URL: https://arxiv.org/abs/0808.1710
Recommendations
state space modelmean reversionpairs tradingdynamic regressionBayesian forecastingstatistical arbitragetime-varying autoregressive processes
Time series, auto-correlation, regression, etc. in statistics (GARCH) (62M10) Applications of statistics to actuarial sciences and financial mathematics (62P05) Statistical methods; risk measures (91G70)
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Cited In (14)
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