Study of statistical arbitrage opportunities in Indian securities market
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Date
2021
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Punjab Agricultural University, Ludhiana
Abstract
Statistical arbitrage is a trading strategy that employs time series methods to identify relative
mispricing between securities based on expected values of these assets. This study is undertaken to
study statistical arbitrage opportunities present in Indian securities market through pairs trading, one
of the most popular techniques of statistical arbitrage. Specifically, the study focuses on the
profitability of pairs trading to common investors and attribution of returns to different risk factors.
The study is conducted across three asset classes and under different scenarios of the underlying
assets involved, viz., stock futures market, stock spot market, stock spot-future market, commodity
futures market, currency futures market, currency spot market and currency spot-future statistical
arbitrage. Daily prices of securities traded and listed on their respective exchanges over 2011–2017
are used on rolling basis to compute the performance of pairs trading based on the selection of pairs
of securities through minimizing the sum of squared deviation (distance method) and cointegration
tests (cointegration method). Pairs trading strategy is executed in two stages: the pairs formation
period and the pairs trading period. The strategy is executed by taking long position in one security
and short position in other security of the identified security pairs. To examine the risk of pairs
trading and the drivers of returns, the portfolio returns are risk-adjusted using Fama and French
(1993) three factor asset pricing model. The study reveals that pairs trading in stock futures is
significantly profitable with average annualized profitability of up to 34% including transaction costs.
At the same time, statistical arbitrage opportunities present in stock spot market and stock spot-future
scenario are not profitable. On the other hand, pairs trading in commodities is significantly profitable,
with average annualised profitability of up to 59 percent, including transaction costs. While currency
spot and currency future market do present statistical arbitrage opportunities, they are not profitable
enough to cover the underlying risk. Meanwhile, the currency spot-future statistical arbitrage
generates annualized return of 10.52% in a near riskless arbitrage scenario. The evidence of pairs
trading profits supports the view that these profits reflect compensation to arbitrageurs for enforcing
the law of one price in similarly related markets to ensure market efficiency. Indian financial markets
are maturing and are attracting sizable retail and institutional investments. Advanced applications like
the one presented in this study are of significance for the investors and investment consultants so that
they can benefit from such trading strategies.
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Citation
Aggarwal, Geetu (2021). A study of statistical arbitrage opportunities in Indian securities market (Unpublished Ph.D. Dissertation). Punjab Agricultural University, Ludhiana, Punjab, India.