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Pairs Trading And Strategies And The CAPM
Finance & Accounting
Pages 20 (5020 words)
PAIRS TRADING AND STRATEGIES AND THE CAPM Name Instructor’s name Banking and finance 23 June 2012 Abstract Pairs trading is a trading strategy used to exploit markets that are out of equilibrium, assuming that overtime they will move to rational equilibrium.
Besides testing a model, this study will also be testing market efficiency and using use Cointegration as a decision rule for pair selection, try to ascertain whether different and more efficient rules may be implemented. In order to calculate asset returns we need the Capital Asset Pricing Model (CAPM) which gives predictions on how to measure risk and the relationship between risk and return. The relationship of expected return is linear and is necessary to explain differences in returns among securities. Introduction Pairs trading include tested methods used to identify and invest in pairs. This was developed by Morgan Stanley in the 1980’s and is today one of the most commonly used strategies in the finance and trading industry. Using this strategy, an investor looks at two assets, whose prices have moved together in the past. As the price spread widens, the investor takes a short position in the outperforming asset and a long position in the underperforming asset hoping that the spread will move back again, thereby generating profits. If history then repeats itself, prices will congregate and the arbitrageur will earn revenue. For example, if the U.S. ...
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