Pairs Trading Analysis Global Asset Allocation Spring 2004

Pairs Trading Analysis Global Asset Allocation Spring 2004 The Hemline Theorists

Pairs Trading Analysis n Introduction n Developing the Model n Results

Introduction n n Long/short, market- and industryneutral strategy Pair selection criteria: • same industry • mature companies • long trading histories • similar exposure to macro factors n Assume reversion to historical value relationships

Developing the Model n Variable selection • Stock price ratio • Dividend yield ratio n Selecting in-sample period and data frequency • Daily data: 1987 -2004

Pairs Trading Analysis: Model Parameters n n n Variables Switched on or off Deviation from mean historical ratio required for trade signal Translation of individual variable trade signals into overall trade signal

Selecting Pairs – Ford and GM GM introduces its "GM 10" family of newly redesigned midsize cars. Restores profitability through streamlined operations. Ford announces highest earnings in auto industry history GM announces a restructuring of its North American sales and marketing operations, replacing marketing division-specific organizations with a single sales

Model Demonstration

In-Sample Optimization n Find the model parameters that: • Maximize average annual return on trade days • Trade on at least 10% of total days • Limit maximum drawdown to 15% • Sanity check to ensure model works over time and is currently valid

Model Parameters

In-Sample Results

Out-of-Sample Results

Extending the Model to Other Pairs Eli Lilly & Merck Coca-Cola & Pepsi

Pairs Trading Analysis Questions?

In Sample Optimization

In Sample Optimization

In Sample Optimization

In Sample Optimization