Computational Management Science

, Volume 8, Issue 1, pp 23–49

Dynamic modeling of mean-reverting spreads for statistical arbitrage

Original Paper

DOI: 10.1007/s10287-009-0105-8

Cite this article as:
Triantafyllopoulos, K. & Montana, G. Comput Manag Sci (2011) 8: 23. doi:10.1007/s10287-009-0105-8

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. 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.

Keywords

Mean reversionStatistical arbitragePairs tradingState space modelTime-varying autoregressive processesDynamic regressionBayesian forecasting

Mathematics Subject Classification (2000)

91B8491B2862M10

Copyright information

© Springer-Verlag 2009

Authors and Affiliations

  1. 1.Department of Probability and StatisticsUniversity of SheffieldSheffieldUK
  2. 2.Department of MathematicsImperial CollegeLondonUK