Cointegration and Relative Value Arbitrage

Abstract

This paper examines a new method of identifying close economic substitutes in the context of relative value arbitrage. We show that close economic substitutes correspond to a special case of cointegration whereby individual prices have approximately the same exposure to a common stochastic factor, or the cointegrating relation is approximately one-to-one. Empirical analysis of cointegration-based pairs trading shows that a metric of closeness constructed from the cointegrating relation strongly predicts the probability of convergence and profitability of pairs trades. Over period 1962-2013, a strategy that trades cointegrated pairs of near-parity generates average returns of 58 bps per month after trading costs, experiences 71% probability of convergence and outperform pairs that are selected using the conventional method of minimizing price distance. When extending to triplets trading, the predictability of the metric of closeness remains, however trading of cointegrated baskets of three stocks is less profitable due to smaller mispricings.