Hedge Fund Strategies in Korean Market: Pair Formation Methods and the Profitability of Pairs Trading with KOSPI100 Stocks
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This paper looks into pairs trading strategy. Stocks in KOSPI 100 are matched into pairs using three different pair formation methods. Ornstein Uhlenbeck process is employed to model the normalized price spreads. The parameters of Ornstein Uhlenbeck process are proposed as a new pair formation method. The empirical result supports that the newly proposed method is suited to Korean market where investors are very risk averse.
Abstract
This paper quantifies the conditions of buying and selling according to three criteria (correlation of stock prices, sum of squared price spreads, and parameter estimates of OU process) without relying on charts or intuitions in pairing the pair trading strategy. Profitability was investigated. As a result of empirically analyzing the trading strategies from January 2011 to June 2012 for pairs made up of KOSPI 100 stocks, the pair formation strategy using the parameter estimates of the OU process showed the highest average return and the lowest profit. It showed a downside risk roll. These results suggest that the new pair formation method using the OU process may be more useful for asset managers who frequently use pair trading or managers of newly launched long-short Korean hedge funds.