Outline
Replicate the pairs trading results in the paper Illuminating the Profitability of Pairs Trading: A Test of the Relative Pricing Efficiency of Markets for Water Utility Stocks.
Use the historical data in the accompanying file csv.
Use the BIC criteria for the number of lags to use in all ADF tests. Consider a max number of lags equal to 10..
Estimate equation (6) in the paper for each of your pairs. Then form the residuals as outlined (see equations (7) and (8) in the paper).
Esimate σ from the estimated residuals.
Calculate the upper and lower bounds for the trading rules as:
UpperBound = +1.0 ∗ δiσˆ
LowerBound = −1.0 ∗ δiσˆ
for i = {1,2,3} and δ = {0.25,0.5,0.75} as in the paper.
Make three time series graphs with the residuals plotted against the upper and lower bounds for each δi.
Fill in the following table with the number of buy and sell signals for each trading rule:
δi Buy Signals Sell Signals
Explain what a buy signal and a sell signal means in the context of pairs trading.
For example, identify the first buy and the first sell signals for the δ1 = 0.25 trading rule and interpret them both qualitatively and quantitatively. How many days is each position held for? What the return on the trade?
