Does Simple Pair Trading Work in FX

Master in Finance & Banking
(2014/2015)
DOES SIMPLE PAIR TRADING WORK IN

THE FOREX MARKET?
AN EMPIRICAL APPROACH
Cristhian Vesga Bermejo1
Georgi Atanasov
CIFF Trustees:
1
Becario COLFUTURO 2014-2015
INDEX
INTRODUCTION.................................................................................................................... 5
CHAPTER 1: OVERVIEW OF THE CURRENCY MARKET ............................................................. 8
1.1 SIZE OF THE MARKET .............................................................................................. 9
1.2 MAJOR CURRENCIES .............................................................................................. 9
1.3 QUOTATION OF THE CURRENCIES .......................................................................... 10
1.4 SETTING A TRADING POSITION ............................................................................... 11
1.5 HISTORY AND CHARACTERISTICS OF THE MARKET ................................................. 12
1.6 FOREX TURNOVER ............................................................................................. 14
1.6.1 Turnover of currencies and different currency pairs ..................................... 14
1.6.2 Turnover of currencies by counterparty ........................................................ 16
1.7 STRATEGIC ANALYSIS: FUNDAMENTAL, TECHNICAL AND QUANTITATIVE ................... 18
1.7.1 Fundamental Analysis .................................................................................. 18
1.7.2 Technical Analysis ....................................................................................... 18
1.7.3 Quantitative Analysis ................................................................................... 19
CHAPTER 2: FUNDAMENTALS OF THE PAIRS TRADING STRATEGY ........................................ 20
2.1 BRIEF HISTORY OF THE STRATEGY AND ITS MAIN CHARACTERISTICS ........................ 20
2.2 THE DISTANCE METHOD ....................................................................................... 21
2.3 USAGE OF THE STRATEGY .................................................................................... 23
2.4 IMPORTANCE OF CO-INTEGRATION IN THE STRATEGY .............................................. 27
2.4.1 Description ................................................................................................... 27
2.4.2 The Concept of the Common Trend Co-integration Model ........................... 29
2.4.3 Necessary conditions for co-integration ....................................................... 30
2.5 APPLICATION OF THE COMMON TRENDS MODEL ..................................................... 32
2.6 SUMMARY OF THE COMMON TREND MODEL ............................................................ 34
2.7 THE AUGMENTED DICKEY-FULLER TEST ............................................................. 35
CHAPTER 3: METHODOLOGY OF THE EMPIRICAL RESEARCH ................................................ 37
3.1 APPLICATION OF THE STRATEGY ............................................................................ 37
3.2 DATA COLLECTION AND STATISTICAL ANALYSIS ....................................................... 40
3.3 ALGORITHM CONSTRUCTION ................................................................................. 44
3.3.1 Tradability of the Pairs ................................................................................. 44
3.3.2 Rolling Window ............................................................................................ 44
3.3.3 Trading Opportunities .................................................................................. 45
3.3.4 Testing the Results ...................................................................................... 47
CHAPTER 4: SUMMARY AND RESULTS OF THE EMPIRICAL ANALYSIS .................................... 48
CONCLUSIONS AND RECOMMENDATIONS .......................................................................... 53
CONCLUSIONS ........................................................................................................... 53
RECOMMENDATIONS .................................................................................................. 54
BIBLIOGRAPHY ................................................................................................................... 55
APPENDIXES....................................................................................................................... 57
TABLES ..................................................................................................................... 57
GRAPHS .................................................................................................................... 57
Does simple pair trading work in the FOREX
market?
An empirical approach
ABASTRACT
Pairs trading is a well-known and widely used strategy in the financial industry. Many
academic papers have been published regarding to this topic, mainly applied over
samples in the stock markets. This project attempted to analyze the application of a
simple pairs trading rule in the Foreign Exchange Market, until now poorly approached.
Therefore, our aim with this work was to address, through an empirical analysis, a
market-neutral strategy that takes into account pairs of exchange rates that move
together and exploits their plausible inefficiencies. Based on a co-integration model, we
designed and tested the strategy, which surprisingly yielded valuable evidence of its
potential scope. The sample employed for the development of this project included 9 of
the most liquid currencies in the market, from 2010 until 2014, so it was possible to
open and close positions at the right moment without delays.
Key words: Pairs trading, market neutral, co-integration, exchange rates.

INTRODUCTION
Does simple pair trading work in the FOREX market?
Quantitative analysis has been present for a long time in the financial markets and with
the introduction of the computers into financial analysis this approach has been
developed faster and consistent until today. This kind of method uses statistics and -
mathematics to explain the behavior of the financial assets, and based on that, they are
employed to take positions in the market. Some models try to forecast, for instance, the
trend of a stock, or the shifts of the interest rate curves, while others look for arbitrage
opportunities using the market neutral concept, objecting to find inefficiencies in the
market.
When Pairs Trading Strategy is considered, it is referred as a statistical arbitrage

examination. What a pairs trading strategy seeks is to exploit the arbitrage opportunities
caused by short term inefficiencies in the market. Basically, the idea is to find two
assets, in this case exchange rates that tend to move together and whenever this usual
behavior is broken we start looking for a trading opportunity buying or selling the spread
between them.
The objective of this project is to show, empirically, the evidence of any

possibility to implement the pairs trading strategy in the Foreign Exchange Market (FX).
Using a co-integration model, nine exchange rates were taken in order to find the best
pairs that move together. Following the tradable pairs selection those that tend to
move together- the spread between the pairs played an important role. The
performance of the spread was examined to develop the strategy, considering abnormal
deviations from its regular behavior. Thus, any divergence from its standard mean would
be considered as a trading opportunity.
In order to achieve the objective of the project, it was necessary to examine the
most recent literature available related to Pairs Trading. Unfortunately, the state of the
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art regarding the strategy implemented in FX market is almost scarce. (Georgios, 2013)
attempted to develop a pairs trading strategy between the EUR/USD and the GBP/USD
without any success, because the length of the time series does not allow a long-term
equilibrium. Besides that, the final recommendations of this work were quite useful for
the purpose of our paper. We increased the number of pairs analyzed and also reduced
the wideness of the periods to find pairs that hold a co-integrated relationship for shorter
periods of time.
However, the literature of Pairs Trading, generally speaking, has significant

achievements and important exponents. Gatev, Goetzmann, and Rouwenhors (2006)
documented the statistically and economically significance of the returns obtained from
a simple pairs trading strategy. They paired, using CRSP daily data, the stocks
minimizing the historical differences (spread) over periods of 12 months, and then
trading them in the following 6 months. The rule was as follow: They consider as
opening spark each time the spread (in the trading period) exceeded the historical mean
by two standard deviations. This study states an important starting point in order to
understand the performance of the strategy, and the main drivers behind its returns.
(Do & Faff, 2010) realized a replication and amplification of (GGR, 2016)
looking for the reason behind the reduction of the profits in Pairs Trading, which they
adjudicated to the increasing competition in the hedge fund industry. Besides that,
evidence was found that during periods of turbulence the likelihood of success of this
strategy increased.
Finally, among other researches that are referenced in our bibliography section,
(Vidyamurthy, 2004) provided the main fundamentals for the appropriate
implementation of the strategy. We found, inter alias, the conditions for pairs selection,
the co-integration framework, as well as the augmented Dick-Fuller test (Fuller, 1976)
for the mean reversion criteria that are going to be explained in detail.
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The remainder of the project is organized as follows. The first chapter begins
with an introduction of the FOREX market explaining its main characteristics.
Furthermore, we expose which are the main types of analysis used to assess the market
(Fundamental Analysis, Technical Analysis and Quantitative Analysis). In Chapter 2,
we introduce the fundamentals of the Pair Trading Strategy, and the principal concepts
of co-integration, divergence and convergence that are vital elements of the strategy are
explained in detail. And finally, Chapter 3 describes the data collection (including the
descriptive statistics of each currency pair), the algorithm construction and the optimal
pair selections. Based on that, Chapter 4 provides the results of our empirical analysis
as well as conclusions and recommendations for future research.
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CHAPTER 1: OVERVIEW OF THE
CURRENCY MARKET
The Foreign Currency Market (FX) is a global market and mainly operates over-the-
counter (OTC). Currency trading could be performed through electronic platforms or by
phone call with various trading desks.
The OTC market is also known as the spot market or the spot currency market
for the purpose of this paper. A spot transaction is explained as an exchange of
currencies at the prevailing current market rate.
Currency traders could perform operations through a centralized exchange. The

FX market is not a real market in the general way, because there is no central trading
exchange. It is a market, which interconnects traders and brokers internationally, who
transfer money from one account to another. Furthermore, currency trading could be
performed through the interbank market, where banks, insurance companies, and large
entities are trading in significant quantities.
OTC market is known as a secondary market. It was developed more recently

and allows small (retail) investors to participate in the FX market. The OTC market is
similar to the interbank market, but there is difference in prices, because the size of the
trades is much smaller.
In general, to trade in FOREX, an investor buys one currency, while at the same
time, sells another currency.
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1.1 Size of the market
FOREX is the largest market in the world, comprising volumes that far much exceed
commodity, financial futures, and equity trading. A suitable example could be the euro
currency, whose trading volume is five times the New York Stock Exchange (NYSE).
FX operates 24 hours a day, from Monday to Friday (including). The market opens on
Sunday at 5 p.m. Eastern time and closes on Friday at 5 pm. Trading begins in Sydney
and continues across the globe through financial centers as Tokyo, London, and New
York.
The FX market allows traders to respond immediately to currency fluctuations

and to take buy/sell position, no matter whether it is day or night time. They can usually
enter or leave the market at any time and there is no need to wait for a liquidity gap,
which is common in equity trading markets. All the information in the currency market
is transparent, which provides all the participants with an equal access of market data.
1.2 Major currencies

There are seven currencies that are traded the most in the world, and are called the
majors. The table below depicts these currencies:
Currency Ticker
Euro EUR
US Dollar USD
Japanese Yen JPY
Swiss Franc CHF
British Pound GBP
Canadian Dollar CAD
Australian Dollar AUD
[TABLE 1]: Major Currencies in global trade
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There are many other currencies traded on the market (Chinese remnimbi), but
the above mentioned are the most actively traded.
1.3 Quotation of the currencies
Each currency is provided with a three letters code (TABLE 1), which is further used in
FX trades. Currencies are generally traded in pairs, and that is how they are quoted on
the market. For example, the Japanese Yen against the Canadian Dollar is quoted
JPY/CAD. The market requires the currency to be traded in a pair with another currency,
and can never be traded by itself only.
There are two options of trade in the market: long (to buy) and short (to sell). For
instance, go long the British Pound versus the Canadian Dollar means that the trader
simultaneously buys Canadian Dollars and sells British Pounds. The first currency in the
pair (CAD) is called the base currency and the second one is named the quote
currency.
The pair is quoted as the units of the quote currency needed to obtain one unit
of the base currency. Lets return to our previous example. If the quote is 2.4563, it
means that 2.4563 Canadian Dollars are needed to obtain one British Pound. In most of
the instances, currency quotes are placed at four decimals. The last decimal of the quote
is called the pip.
Another theoretical part behind currency trading is the bid-ask spread. Currency
pairs are often quoted at this spread. The bid price is the amount you will get in
exchange for one unit of the base currency. The ask price represents the amount you
need to spend in order to obtain one unit of the base currency. Spreads fluctuate
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depending on the supply and demand for particular traded pair of currencies. For
example, the spread of EUR/US is usually in the range 2-7 basis points (bp), but the
spread of the EUR/GBR could reach 15 bp.
In our previous example, if the pair is quoted as 2.4563/2.4565, it means that a

trader can buy the Pound at 2.4565 and sell it at 2.4563. Mostly the quote is expressed as
follow: 2.4563/65, since only the last two digits differ.
In case the market is expected to move lower in near future, short selling is not
restricted as it is the case with equity trading. The explanation behind this is that
currency trading involves buying one currency and selling another one, providing the
same ability to trade in an increasing or decreasing market.
1.4 Setting a trading position

Only regulated companies may trade in the off-exchange FX market. Retail trades in the
market are not guaranteed by the so-called clearing house.
A trading account is established by providing a margin deposit, a deposit hold by

a dealer to cover probable losses. This margin deposit is required before you can start
trading currencies, but is also apparent in derivatives trading, which falls outside of the
scope of this paper. Mostly, a small amount of money (margin deposit) could allow the
FX participant to hold a position that worth many times the initial margin. In the
currency markets, and not only, this occurrence is knows as leverage. The leverage
magnifies the profits and losses of the participant, since he/she is allowed to manage
much larger amount of currency than his/hers initial deposit.
Another term in currency trading is the margin call. It represents an involuntary

stop of the account, mainly when the losses of the position exceed the initial margin. In
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the FX market it is possible to limit your losses, which protects you from extra payments
to financial firms, when the losses are greater than the initial deposit.
1.5 History and Characteristics of the Market
FOREX is considered to be the largest financial market on a global scale. Its daily
turnover is over $1 trillion, an amount 30 times bigger that all of the US equity markets
combined together.
Generally speaking, there exist two reasons to buy or sell currencies. Closely to
5% of the daily turnover is generated by companies and governments that buy or sell
goods or services in a foreign country, or need to convert profits from foreign to
domestic currency. The other 95% of the trading activity is generated with the sole
purpose of profit or speculation.
The most traded currency, called The Majors (TABLE 1), provide the most
suitable trading opportunities for speculators. More than 85% of the global currency
trading is performed by The Majors, which include the US dollar, the British pound,
the Japanese yen, the Swiss franc, the Canadian and the Australian dollars.
When a FX position is considered, a trader is long in one currency and short in

another. A short position occurs when the investor sells a particular currency with the
expectation of currency devaluation. The majority of the transactions are performed on
the spot market. It is a contract for immediate delivery of one currency in exchange for
another one. Mostly the exchange rate of this transaction is called the spot exchange
rate. The advancement of technology nowadays eliminates the potential risk of one party
falling to fulfill its obligation. At present, the most traded contracts on the FX are spot
contracts comprising up to 90% of all FX transactions.
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In order to reduce FX risk practitioners employ hedging strategies through the
use of derivative instruments. The following instruments are available to the market:
forwards, swaps, futures, and options. Each one of them is described briefly below:
Forwards
The forward contract is different from a spot contract in that the delivery of the
currency is set in the future. The exchange rate of the transaction is defined today, but
the delivery takes place in the future. The time to maturity is different, depending on the
type of the contract and the agreement between both parties. Forward contracts are
customized, since there is no clearing house between both parties. The transactions are
executed over-the-counter (OTC).
Swaps
A swap contract is a combination of a spot sale of a foreign currency with the future
repurchase of the same currency. This type of contract is usually used by counterparties
who deal in the same currency pair. The combination of these two transactions reduces
the overall transaction costs for each of the participants. The transactions are executed
OTC.
Futures
Futures are derivative contracts that are similar to forwards, but with some key
differences. In futures the contracts are standardized by a clearing house.
Standardization sets certain maturity dates of the contracts, which could be traded only
on organized exchanges, and not in OTC. Another difference between forwards and
futures is that in futures participants are required to post initial margin, which will serve
as a partial compensation to one of the parties when the other one fails to fulfill its
obligation. Additionally, a maintenance margin is also required by the repository. The
maintenance margin defines the amount of the account, which should be kept constant.
The clearinghouse calculates this margin every day and if there is inconsistency, the
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market trader receives a margin call, which requires re-balancing its account to the
initial margin.
Options
Options are contracts that provide one party, the buyer, with the right but not with the
obligation to fulfill a transaction (either buy or sell) in the future. The exchange rate is
specified before the transaction takes place, and the delivery date is also defined. The
buyer of the option may not execute the trade, if the spot rate at execution date is lower
than the pre-agreed rate. The seller of the option will keep the premium paid to him/her
for selling the option.
1.6 FOREX Turnover

The Bank for International Settlements (BIS) conducts a survey, called Triennial
Interbank Survey, which measures the FX turnover. The latest data available depicts the
turnover for 2013.
The survey shows drastic increase in global FX trading up to $5.3 trillion per day
apparent in 2013, an increase from $4 trillion in 2010, as it is indicated in (Table 2).
1.6.1 Turnover of currencies and different currency pairs

The currency configuration of FX trading on a global scale changed notably in between
the period 2010-2013. This change was visible not only for the worlds most trading
currencies, but also among the most important emerging markets currencies. As an
example, the Japanese yen advanced significantly in terms of trading activity as a major
currency, while the euro experienced a decline as an internationally intensive trading
currency for the period. Among the major emerging markets currencies, the Mexican
Peso and the Chinese Yuan gained the most (Table 3).
The dollar is known as the most traded currency in the world. In April 2013, its
share as the one currency in a pair represented 87% of total trade. (Table 3)
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Among the other trading currencies, the Japanese Yen experienced an increase of
63% in trade for the period under observation. Moreover, the turnover of the USD/JPY
pair increased by 70% for the same period This resulted in an increase of the Yen as a
globally traded currency by 400 basis points to 23% in April 2013 (Table 3). Market
analysts consider the increase in the yen trading happened around the end of 2012,
because at this time the Japanese Government announced monetary policies to stabilize
the economic situation.
On the other side, the sovereign debt crises in the European Union shrunk the
international role of the euro as a major trading currency. The euro remained the second
largest currency in terms of trading volume, but its international market share declined
by almost 6% compared to 2010, where it had 39.1% market share.
The Australian and the New Zealand dollar advanced significantly among the
currencies of the most developed countries. In contrary, the national currencies of
Sweden, Canada, and Switzerland lost ground in the international trade.
[Table 2]: Global Foreign Exchange market Turnover (1998-2013), in $Billions
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[Table 3]: Currency Distribution of global foreign exchange market turnover
1.6.2 Turnover of currencies by counterparty
The segment that contributed the most for the growth in currency trading was
performed by other financial institutions (Graph 1). This class represents small banks,
institutional investors, alternative investment vehicles as hedge funds, etc. Graph 1
also depicts that the major contribution for the turnover of these other financial
institutions was brought by the non-reporting banks (24% of total global currency
trade). Other major players are institutional investors and hedge funds, with 11%
market share each. It could be noticed also that the official sector represented by
national banks and sovereign funds accounts for 1% of the trades in the market.
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[Graph 1]: FX turnover by counterparty
Source: BIS Triennial Central Bank Survey, April 2013
As it can be seen in Graph 2, most of the market shares of the different financial
instruments used to hedge risk in the currency markets remain relatively the same. The
FX swaps were the most traded instruments, while the currency swaps accounted only
1% of the market trades. It could be indicated also that the FX over-the-counter (OTC)
instruments like forwards and options experienced a slight increase in market share.
[Graph 2]: FX turnover by traded instrument

Source: BIS Triennial Central Bank Survey, April 2013
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1.7 Strategic Analysis: Fundamental, Technical and Quantitative
1.7.1 Fundamental Analysis
Fundamental analysis is heavily used in equity examination to measure a companys true

value and to directly reach investment decisions based on this true value. FOREX
traders imply the same fundamental evaluation methods, but the assessment considers
currencies and their respective countries. Economic data is used in order to define the
true value of particular currency.
The economic data and political events are measures similar to the news that
comes out for particular company to determine its fair value. This fair value changes in
time due to factors such as economic growth and financial strength of the company.
Fundamental analysts use this data to obtain information about the strength of a
countrys currency.
1.7.2 Technical Analysis
Technical analysis is used by market participants in order to forecast price movements

by simply observing the market-generated past data. The most observed past data in
technical analysis concerns price, volume, and futures contracts scale. Methodologies
with a proven track record are implemented as the fundamentals of the analytical
method.
Every professional trader in the market uses technical analysis. Even participants,
who base their trading strategies mostly on fundamental analysis, also implement price
charts (technical) to come up with a trading position. These types of charts are relevant
for traders, because they provide suitable information of when to enter and exit the
market. Furthermore, it also delivers graphical representation of the historical price
action of a currency pair or any other financial instrument. This helps traders to take a
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look at a chart and decide if they are trading at a fair price (based on past performance),
and when they can sell at the cyclical top. These charts are only part of the whole range
of graphical representation that could be used as part of technical analysis, and are one
of the tools in this paper to be used in order to reach an understanding of the market
behavior.
It may appear that technicians exclude the fundamental analysis at first glance by
only using graphs and charts, but the better relevant assumption is that technicians adopt
the notion that fundamentals are already represented in the price. Technicians are not
particularly interested whether a natural disaster or an inflation announcement causes the
price of particular financial asset to appreciate or depreciate, but whether this price
movement fits into a trend or pattern. Most importantly, how this pattern can be used to
predict future prices.
1.7.3 Quantitative Analysis
Quantitative analyses are based on computational statistics. Such examination is used to

reveal a trading opportunities in the market. Some of the most common data inputs used
are price and volume changes, which are heavily applied in mathematical models.
Quantitative trading is mostly employed by hedge funds and financial entities, which use
large in-size transactions as well as financial instruments. Nevertheless, quantitative
trading is also used by individual investors.
Quantitative trading includes high frequency transactions, algorithmic trading,

and statistical arbitrage. In general terms, these strategies distort the market by
increasing its volatility and by employing mostly short-term horizons. Quantitative tools
as moving averages and oscillators are some of the analytical tools used by individuals
to observe the past performance of the market in order to predict future movements.
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Chapter 2: Fundamentals of the
Pairs Trading Strategy
2.1 Brief History of the strategy and its main characteristics
One of the main characteristics of the pairs trading strategy is that it relies on a market
neutral strategy. This is a strategy that is neutral to market returns, which means that its
correlation with the market is negative. The uncorrelated element implies that no matter
whether the market moves up or down, the market neutral strategy accomplishes in a
steady manner and results are achieved with a lower level of risk.
Pairs trading, also referred to as statistical arbitrage by researchers, is a trading

strategy which was first introduced by Nunzio Tartaglia 30 years ago. He was the
principle of a group of mathematicians, physicists, and computer scientists, who
gathered together at the US bank Morgan Stanley. The main purpose of these
researchers was to create a trading system, which will be automated in nature to take
advantage of distortions in the market (mispricing). Mispricing creates arbitrage
opportunities, which are often hard to detect, because the true values of the securities
traded on the market are not known with certainty. The pairs trading strategy uses the
movement between the relative values of two stocks (the pair) in order to spot
mispricing, and do not rely heavily on true security prices. The strategy was extremely
profitable when implemented in the past, but as knowledge and technology advanced
practitioners believed that the profits from pairs trading dropped, while at the same time
the risk of using this strategy augmented.
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As already mentioned, pairs trading relies on a market neutral strategy. A market
neutral portfolio is constructed using two securities, consisting of a long (buy) position
in one of the securities and a short (sell) position in the other. A predetermined ratio
should be defined in order to successfully implement the strategy. In any single point in
time the portfolio is considered as having a quantity called spread. In general, this
quantity is calculated by using the quoted prices of both securities in a time series form.
When the spread is at certain amount (two standard deviations for the purpose of this
project) away from its mean value, the trader can open the positions described above
(short the overpriced security and long the underpriced one) with the presumption that
the spread will equalize (converge) in future.
Even though some researchers believe that there is only one main pairs trading
strategy, there exist more methods to benefit when using it. Examples of alternative
methods of pairs trading are: the distance method, the co-integration method, and the
stochastic method. For the purpose of describing the pairs trading in equities, the most
widely used method, namely the distance method will be described. The co-integration
method will be described and tested in our currency experimental approach.
2.2 The Distance Method
The distance method takes into account the sum of squared differences of two
normalized stock values. Historical data is used to estimate the risk (volatility) of the
spread of these securities. Usually the trading trigger used in pairs trading is set to be
two standard deviations from the mean spread. When this occurrence appears, the stocks
are considered to be mispriced in terms of their relative value to each other. This is the
moment where traders could buy the underpriced security (buy cheap) and sell the
overpriced stock (sell expensive). They will benefit from this strategy if in future (long-
run) the relative price levels of both stocks return to their means. When stocks deviate
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from their prices up to two standard deviations, the securities are experiencing a
divergence.
The distance model is considered as a non-parametric model, which does not rely
on stock prices following particular behavior. Therefore, the model does not include
fixed parameterized simulations or possible errors from stocks deviation from their
means. Moreover, the usage of relative security prices reduces the volatility in co-
funding variables intrinsic in stock prices, like the inflation rate for example. However, a
critical assumption of the model is the usage of two standard deviations (divergence)
between the price levels of a pair of stocks. This divergence of price-levels could
magnify large losses for investors, especially if a stop-loss order is not also
implemented. Another disadvantage of the model could be considered the lack of
reliable forecasting ability to predict the convergence phase and the expected holding
period of the securities.
One main apprehension of pairs trading and its increased popularity is its
profitability. Many practitioners believe that a pair trading is only beneficial to the first
investors that are able to profit from the arbitrage opportunity or from the temporal
inefficiencies in the market. They support the thesis that when information about
particular investment opportunity spreads, the inefficiency is eliminated almost
immediately.
Even though pair trading is considered to be an arbitrage strategy, it could not be

observed as risk-free. The major element of applying this strategy is to identify pairs and
construct an efficient trading algorithm. As pointed out earlier, traders benefit from
mispricing in the market, when buying underpriced and selling overpriced securities.
This generates a portfolio of stocks consisting of long position (buy) in one security and
short (sell) position in another. The expectation that prices will return to their means
(mispricing will correct itself) will ultimately reverse the positions in the portfolio.
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2.3 Usage of the Strategy
A practical example could further clarify the trading strategy. The process of forming a
pair is not insignificant, but there are securities in the market that are obviously pairs.
For example, an obvious pair could be formed of the following two companies stocks:
British Petroleum (BP) and Royall Dutch. Both of the companies are producing oil in
Europe, which makes them attractive for comparison. One can easily assume that the
stock price of each of the companies depends on the movement of the oil price, which
makes the movement of the security prices comparable. For the purpose of this example,
lets assume that the share price of BP is traded 5 times a share of Royal Dutch. Lets
also assume that at Jan 1st, 2015 we were able to buy one share of Royal Dutch for 30
and one share of BP for 158. Having into consideration that 5 times 30 is 150, we
conclude that the price of BP is overpriced or the price of Royal Dutch is underpriced, or
even we consider both occurrences simultaneously. A trading strategy we could
implement is to sell one share of BP and buy 5 shares of Royal Dutch, by expecting BP
becomes cheaper or Royal Dutch becomes more expensive. Once again the simultaneous
occurrence is also considered as an option. If we keep our previous assumption about the
stock prices at Jan 1st, 2015, we would have experienced a profit of 158 - 150 = 8. As
a conclusion, this strategy does not provide information about the real price of the
securities, but only reveals evidence about their relative values.
Further example could be extracted from the paper of Gatev, Goetzmann, and
Rouwenhorst (2006), which tested the pairs trading performance of a Relative-Value
Arbitrage. They implemented a two-stage pair trading strategy: the formation period
(formed from pairs on 12 months basis) and the trading period (the next 6-month
period). Both periods (the 12 and 6-months after that) are chosen randomly and
remained the period employed to test the strategy. In relative terms, the strategy of the
authors sell stocks that were doing well and buys stocks that were doing bad relatively to
their match. The price divergence/convergence is formed due to price movements of the
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bid-ask quotes. Conditional on convergence, the winner stock (sell) price is more likely
to be an ask quote and the loser stock (buy) price is likely to be a bid quote. Considering
the other way around, when divergence is taken into consideration, the drop in the
winners price could be explained by a bid quote, while the rise of the losers price could
be explained by ask quote.
The authors of the paper mentioned above paired all the liquid stock of their
sample, shaped during the formation period. After that, they examined the top 5 and top
20 pairs based on the smallest distance measurement, in addition to the top 20 pairs after
the first top 100 (pairs 101-120). This last set is important because the top pairs share
some common characteristics. The day after the formation period is finished serves as
the trigger of the trade. The trade is performed through a pre-specified rule, which will
be described shortly.
Graph 3 below depicts graphically the strategy using a pair of two stocks:
Kennecot and Uniroyal. The Graph represents the 4-months period starting in August
1962. The top two lines represent the price paths (normalized) taking into consideration
the re-invested dividends. The bottom line depict when the trade is opened or closed on
a daily basis. As it can be seen in the graph, both stocks move together during the
trading interval, which makes them perfectly paired. It could be also noticed that the
trading strategy opens for the first time in the 7th day of the period and closes at the 36th
day. At the 36th day the spread converged, which is the indication to close the trade. As a
reminder of the previous sections, the trade is opened when the spread increases to two
standard deviations from the mean. Further evidence of the relevance of the strategy is
that it opened 6 times during the observed period of 120 days. In this example, it could
be seen that convergence occurs at the last day of the period, which is rarely the case.
The strategy that the authors employed was to open a long-short position when
the pairs diverge two standard deviation from the mean spread. The position is closed
24
when the mean spread converge again. The whole strategy is based on the standard
deviation metric. If a trading position is opened and the convergence of the prices does
not occur before the end of the trading period, the gains and losses are calculated at the
last day of the trading interval. Furthermore, if a particular stock is delisted from an
exchange, the position in the pair is closed using the last trading price of the delisted
security.
[Graph 3] Pairs Trading Strategy with normalized returns (August 1963 -

January 1964)
Table 4 provides a summary of the empirical results regarding the pairs trading
strategy using a sample of 120 pairs for a period of approximately 40 years. The pairs
were not always formed by combining two securities in the same industry. Panel A
depicts the excess returns of the pairs having into consideration that positions are opened
when the mean spread diverge by two standard deviation, and closed when the mean
spread converge to its historical mean. Positions are opened and closed at the end of the
trading day for both occasions.
25
[TABLE 4] Empirical Results of the strategy (July 1963 December 2002)
The first line in the table provides the empirical evidence that a fully invested
portfolio of the 5 best pairs netted 1.38% of an average excess return, a result which is
statistically significant. Going forward, a portfolio which includes the best 20 pairs
resulted in 1.44% of average monthly return. It could be observed in the table that when
the number of the pairs in the portfolio is increased, the risk of the portfolio measured by
its standard deviation decreased (line 5). Furthermore, the diversification benefits could
be established from the minimum and maxim returns. It could be observed that the
minimum return increased (line 8), while the maximum returns stays relatively stable
(line 9). These results indicate that the pairs trading strategy is profitable.
Panel B represents the results when the trade is open one day after the divergence
of the mean and closed one day after the convergence. It could be seen in the table that
the average excess return for a fully invested portfolio of pairs decreased by 30 basis
points for the period. Even though the excess returns remained relatively positive, the
drop of 30 bp suggests that part of the profits in Panel A are non-trivial due to the bid-
ask bounce during the period. The diversification effect is once again described by the
26
decreasing value of the standard deviation of the portfolio when the number of pairs in
increased.
2.4 Importance of co-integration in the strategy
2.4.1 Description
Empirical research includes time series of information. In general terms, financial and
economic time series imply stochastic processes. This method allows the researcher to
use statistical inference to test relationships between variables. Lets assume that we
have two drunken people, who walk randomly (two random walks). Both persons do not
know each other, which make them independent (no relationship between them).
Now lets adopt the situation of a drunken person, who is walking with his dog.
This time we can assume that there is relationship between them, but how strong it is?
We could notice that the path of the person and the dog is relatively unpredictable
random walk; if we know the location of one of the variables we can easily approximate
what the location of the other variable is. Furthermore, the distance between them could
also be established. For example, if the dog moves far away from its owner, he/she will
continue its walking towards the direction of the dog in order not to lose it. This
situation provides us with the opportunity to describe this relationship as a co-integrated
pair.
Other examples of co-integration could be considered the following:
Income-consumption relationship: when income increases, so does consumption.

The size of police force in particular football game and the criminal activity on
that day.
27
A movie created based on a book: even though they could differ sometimes, the
general idea stays the same.
The amount of patients leaving or entering a hospital.
So why is co-integration so important? It is assumed that in quantitative finance

the concept of co-integration allows traders to form the bases of establishing pairs
trading strategy. Returning to our previous example with the two co-integrated stocks
(Royal Dutch and BP), which we could define as stock A and stock B respectively. We
could further establish the relationship as A-5B = C, where C is an inactive series of zero
mean. The co-integration relationship could be defined as such that the price of stock A
is five times bigger than the price of stock B. Given that A is 5 times B, we could
reasonably assume that the price of A will move down and the price of B will move up.
This allows the following trading strategy: if A-2B > D, where D is a positive threshold,
we could sell stock A (overpriced) and buy stock B (underpriced). In this strategy we are
assuming that the price of stock A will decrease and the price of stock B will increase.
Why is it necessary to use the concept of co-integration, when there is possibility

to use the R-squared method to define relationship between two variables? A reasonable
explanation is that the usage of standard regression analysis fails to perform well when
non-stationary variables are implemented, which will ultimately lead to spurious
regressions that suggest relationship even though there might be none at some point.
The concept of correlation is used by practitioners in testing co-movements of

assets, but could also be applied to co-movements of returns. Correlation is a metric
used to establish the strength and the direction of linear relationship between given
variables. Correlation can be identified as the co-movement of stock prices or return,
while co-integration involves the co-movement of both assets or the logarithm of the
stock prices. Co-integration and correlation appear to be similar concepts, but they vary.
It is possible that high correlation does not necessary lead to co-integration, and co-
28
integration does not necessary lead to high correlation. It is possible that co-integrated
series have low correlation some time. To depict this occurrence with an example, lets
assume that we possess large and well-diversified portfolio of stocks, which are also
represented in an equity index. Lets also assume that the weights in the portfolio are set
to be equal to their weight in the index. This makes the stocks in the portfolio co-
integrated with the index itself, since their weight composition is equal. Even though the
movement of the portfolio could be similar to the movement of the index in the long-
term, there will be stocks in the index (not included in the portfolio) which will perform
exceptionally in terms of price movements. Following this logic, correlation between our
variables (portfolio and index) could be low for some period.
2.4.2 The Concept of the Common Trend Co-integration Model
The Common Trend model is used to explain if two time series2 are co-integrated. The
primary idea of the model is to decompose the time series as the sum of two
components: a stationary and a non-stationary (the common trend component).
The common trend model involves two time series. They can be expressed with
the following equations:
In equations 1a and 1b, and represent the common trends or the so-called
random walk components of the two time series, or the innovation sequences. The
elements , are considered to be the stationary components of the series. If it
2
Time series involves the measuring of values throughout time. Time series could be deterministic, in which case
the values are consequent of a fixed formula. Alternatively, the values could be obtained by using a sample of a
probability distribution, in which case they are called probability or stochastic time series.
29
appears that the two time series are co-integrated, and should be identical up to a
scalar. This equality could be expressed by the following equation:
Where (the scalar) is the co-integration coefficient. There are two important
implications of the model, which are summarized below:
The innovation sequences should be perfectly correlated in a co-integrated system
The innovation sequence of a random walk is defined by differentiating it ( ).

Innovations obtained from common trends should also be identical up to a scalar. If two
variables are identical up to a scalar (the co-integration coefficient) they must be
perfectly correlated. Additionally, when the co-integration coefficient is positive, the
variables (innovations in this case) are perfectly correlated and negatively correlated if
the coefficient is negative respectively.
The Regression (linear relationship) of the innovation sequences against each other
could provide the co-integration coefficient
The co-integration coefficient could be defined with the following formula:
( )
2.4.3 Necessary conditions for co-integration
As it was already determined, the innovation sequences derived from the common trends
should be perfectly positively correlated. It should be also indicated that there are two
visible correlation measures. One of these correlation measures is the innovation
30
sequences described above (the correlation value is either +1 or -1), and the other one
can be calculated on the innovation sequence of the whole series by considering both the
common trend and the stationary component. The latter correlation measure could
comprise a whole range of values depending on the stationary components. Very
important part of the whole concept of these correlation measures is that they are very
different.
The second important point refers to the stationarity of the common trends and
the specific components of the two times series observed. The common trends could be
stationary on non-stationary, which is not critical for the co-integration test. On the other
side, the specific components should be stationary time series, an element which is
assumed in the common trends model. Therefore, in order to establish co-integration, the
specific components should be stationary. It is also vital that the specific component
should not be a white noise3, because if this is the case (the different time series are
white noise), the specific time series would be a random walk, which is a non-stationary
series. This ultimately violates the important condition of stationarity for the specific
component, which means that the first difference of the specific component must not be
white noise.
To summarize this section, there are two important conditions for a co-
integration to exist in a common trend model. First, the innovation sequences, which
were derived from the common trends of the two series, must be identical up to a scalar.
Second, the specific components of the two series must be stationary (Vidyamurthy,
2004).
3
The white noise is defined as the simplest case of a probabilistic time series. It is constructed by
choosing a value from a normal distribution at any point in time. Additionally, the parameters of the
normal distribution are constant and do not change in time. Conclusively, the time series are constantly
drawn from a probability distribution.
31
2.5 Application of the Common Trends Model
Having provided information of the model, let us observe how it is applied in

practice. Its implementation is only possible if we divide the time series into stationary
(innovation sequences) and non-stationary (the specific elements).
In order to test the application of the model, a logarithm of the stock price could
be created as the sum of a random walk and a stationary series. This could be depicted
with the following formula:
Where is the random walk and is the stationary element. When the
difference of the logarithm of stock prices is taken into account, the sequence of returns
could be obtained. Consequently, the return R at time t might be separated into two
fragments as follows:
Where is defined as the return resulting from the non-stationary element, and
is the return explained by the stationary element.
It can be noted that the return which is described by the trend component is the
same as the innovation sequences derived from the trend factor. This means that the co-
integration criterion relating to the innovations sequences of the common trends could
be rephrased in the following way: it there are two stocks, which are co-integrated, the
returns from their common trends should be identical to a scalar. One relevant question
32
the reader might ask is why should the returns of two stocks be identical? This relation is
explained by the Arbitrage Pricing Strategy (APS), which separates stock returns into
common returns (stock return is dependent on different market risk factors) and specific
returns (explicit to the stock). If two stocks face the same risk factors, the common
factor returns should be identical for both in absolute terms. This fact supports the
practitioners choice of when two stocks have a common factor return components.
Another important element of the Common Trend Model and specifically for the
Pairs Trading Strategy is the spread between the prices of both securities. The return of
the pairs trading strategy (long one security and short the other) could be identified by
differencing the spread time series. When the difference of the return series is taken into
account, the spread series can be expressed as the sum of two elements. The first one is
the common spread factor, which is the incorporated common factor return. The second
element is the so-called integrated specific return, which could be named the specific
spread. The relationship described above could be expressed with the following
equations:
When it appears that both stocks are co-integrated, since the and
are supposed to be equal, then the is equal to 0. This occurrence could
be used to reach the conclusion that when the stocks are co-integrated, there is no
difference between the spread of the portfolio and the spread calculated taking into
account the specific elements.
33
Co-integration requires the spread series to be stationary, and this could be the
case only if the spread due to the specific spread is stationary. The specific spread will
be stationary if the integration of the specific returns of the individual specific returns of
the stocks is stationary (Vidyamurthy, 2004). This could also be considered as the main
argument between the relationship of APT and co-integration. Ultimately, if this
assumption is evident, all the requirements for co-integration of two variables will be
served completely.
2.6 Summary of the common trend model
The main idea of the model is to observe a given time series as the sum of a stationary
and non-stationary elements. This is in fact often used by practitioners to reach
investment decision by observing the past behavior of the market. Additionally, the
arbitrage pricing model explains that every risk factor is allied with a time series of
returns. When the sum of the weights of these series is considered, the expected return
series of the stock are obtained. The sum of the expected and the specific return series
results in the actual returns of the security under consideration.
Another important assumption of the model is that when two stocks encounter the
same risk factors, they will ultimately have the same common factor returns. Put in
another words, when a short-long portfolio is considered, the common factor return of
two stock equals zero. Going forward, the stationarity of the specific return factors of the
stocks implies that they are co-integrated. Therefore, in order to test a pair of securities
for co-integration, practitioners should consider the common risk factors exposure of both
stocks and how closely related they are.
34
2.7 The Augmented Dickey-Fuller Test
In order to test whether two time series are co-integrated, a practitioner could employ the
Augmented Dickey-Fuller Test (ADF) on the residual components. The ADF model
tests for the unit root of a given time series sample. It differs from the normal Dickey-
Fuller test in that the former includes larger and more complex sets of time series
models. The ADF statistic applied in the test is a negative number. The bigger this
negative number is, the stronger the rejection of the hypothesis that a unit root exists at
some confidence level.
The ADF model tests for the stationarity of variables that are based on time
series analysis. As described in previous sections, the time series analysis has major
implication in defining the relationship of two variables. In the beginning of 1970s,
Granger and Newbold (1974) reached the notion that macroeconomic data contains
stochastic trend, which is generally described by the unit root. Additionally, they also
concluded that the implementation of this data into an econometrics models could lead
to spurious regression. This results in the vital importance of testing for stationarity,
since the final results of the regression could be fictitious. In general terms, series are
stationary if they satisfy the following conditions:
The mean of the observation does not change in time

The variance of the observation does not vary in time
The covariance of two variables does not change in time, but might be dependent on
the lag length
If the above conditions are not met, the time series are non-stationary (based on a
trend). It is important to mention that in a stationary series there is no relationship
between past values, while the non-stationary variables provide misleading information.
35
The formal test for stationarity used in this project is the ADF test. It is the
extended version of the simple Dickey-Fuller test, since the researches added extra lag
values of the dependent variables in order to remove the problem of autocorrelation.
Lagged values are added constantly to the existing model until the autocorrelation of the
variables is eliminated. The whole process could be described by the following
equations:
(Eq. 7b)
(Eq. 7c)
And consequently,
In the above equations it could be seen that lagged values are added in order to
eliminate the autocorrelation occurrence.
The ADF checks for stationarity at the significance levels of the first and after that of the
second difference. This could be expressed mathematically with the following equation:
The most important conditions that could be satisfied in the above equation are:
.
Homogeneity should be evident (equal variance).
The coefficient should be stable over time.
There should be normal distribution of the errors.
36
Chapter 3: Methodology of the
Empirical Research
Now that the theoretical framework behind pairs trading strategies was explained, we
proceed to describe the set of rules defined for the strategy implemented in this project.
The strategy is based on the conditions of the market, the theory of the common trend
model and the test for co-integration. First, the detailed strategy followed in the project
is described, where all the concepts mentioned earlier are employed, and each of the
conditions that must be fulfilled is stated, so that a trading position in the market could
be initiated. Second, a brief statistical description of the exchange rates is presented,
where their main features are analyzed. This established the base line to take the main
assumptions and advantages of our trading strategy. Finally, information regarding the
algorithm used to apply the strategy is provided. Exchange rate prices were used as
inputs in the model, while the returns of the pairs selected were the outputs.
3.1 Application of the strategy
The pairs trading strategy could be summarized as finding the perfect partner for a given
asset, in our case a given exchange rate. The main idea is to identify two exchange rates
that move together. Thus, to form pairs of exchange rates the Common Trend Model
(CTM) was used. It perfectly explains that two assets, which tend to move together,
must follow two conditions. The first one states that the assets must have a perfect
correlation in the common trend component, that is to say, a positive or negative
correlation coefficient (+/-1). In order to calculate this in stocks, the APT4 is used since
it allows isolating the common components between two securities, taking into account
4
Arbitrage Pricing Theory. Ross, S. (1976)
37
the relation of these securities with macro-economic factors or indices. Nevertheless, the
same application with exchange rates is rather complicated, and there is not any
evidence of a proper implementation in the FX market. Therefore, we basically rely on
the second condition of the CTM, which states that the integration of the stationary
components of the two securities must present a mean reverting performance.
It is important to answer the question of why we rely only on the second

condition. If two time series of two exchange rates are considered to be co-integrated,
and if it can be seen that the residuals of the linear regression between these two time
series provides a stationary performance (ergo, they present a mean reverting behavior),
it could be concluded that the common trend factors of both exchange rates tend to be
closely similar. In case any deviation from the regular performance between the two
time series (this can be observed in the spread or residuals) is corrected within a certain
period of time, then there is a presence of two exchange rates that move together and
this is essentially what is important for the implementation of our strategy.
Another important fact that needs to be stated is that in the combination of time
series, in order to define if they are or are not co-integrated, the order of the factors does
affect the results. If we have two exchange rates (x and y), then the linear regression
between x (as dependent variable) and y (as independent variable) may result as co-
integrated, whilst the linear regression between y (as dependent variant) and y (as
independent variant) may not result as a co-integrated pair. Subsequently, this fact was
considered in the construction of the algorithm used to test the strategy.
Once the tradable partners for a given period of time were identified, the
evaluation of the strategy continues as follows: during a period of 180 days5, each time
that the spread between them exceeded above or below certain thresholds (referred as
5
Normally the studies in stocks assume a period of 12 months, but this is chosen arbitrarily, and we
decided to use 180 days (around 6 months), so that we could find more tradable pairs, because exchange
rates do not usually stay co-integrated for long periods of time
38
divergence), the strategy is activated, because there is an assumption that within a short
period of time there will be a convergence to the historical mean of the spread, and the
idea is to exploit this inefficiency. The two thresholds are the following:
(Eq. 9a)
(Eq. 9b)
, where mean refers to the historical average of the spread and is the historical
standard deviation from the mean spread, which is multiplied by 1.96, because when a
normal distribution behavior is observed, almost two standard deviations from the mean
describe 95% of the observations. Any observation outside this limit is considered as
anomaly, or divergence in our case.
When the spread reaches the upper bound it can be assumed that the dependent
variant is over-valued and the independent variant is under-valued. This activates our
strategy to take a short position in the dependent exchange rate, and a long position in
the independent one. Going forward, if the lower bound is exceeded, then the strategy
considers the dependent exchange rate to be undervalued and the independent to be
overvalued. This position would be the opposite than before and a long position in the
dependent exchange rate will be executed, while a short position in the independent
exchange rate will be implemented simultaneously.
Before continuing with the final step of the strategy, its important to extend the
explanation of the positions, once the strategy is activated. In Equation 10, it could be
perceived that from the construction of the spread, the relationship between the two co-
integrated exchange rates (A and B) is well defined by the co-integration coefficient, and
then the weights of each trade in the transaction must hold this relationship 1: , for this
39
reason, if the spread exceeds the upper or lower bound we would take for 1 unit in the
dependent variant units of the independent.
Consequently, if any transaction is activated we compute the return between the

moment the trade is opened and the moment it is closed. So, to close a trade two
conditions are considered: first, when there is a convergence to the mean spread, that is
to say, if the upper bound was exceeded, the next value of the spread below the mean is
going to be the closing point. If the lower bound was exceeded, then the next value of
the spread above the mean spread would be the closing point. Second, if none of the
conditions exposed before are met, i.e, if there is no convergence, we would unwind the
transaction at the last day of the trading period (the 180th day of the window).
Finally, to summarize the pairs trading strategy in the FX Market, the Common
Trend Model was used to find the pairs of exchange rates that move together.
Running a linear regression between the logarithm of the prices, as was explained in the
Common Trend section, the stationarity of the residuals of the linear regression was
tested to define whether there is mean reversion in the spread, which resulted in pairs
being co-integrated and tradable. After defining the tradable pairs, we evaluated the
trading opportunities considering a trigger, when one of the two thresholds are
surpassed, and finally we calculate the return of the transaction if there is a convergence
to the mean spread or if the trading period is over.
3.2 Data collection and statistical analysis
To evaluate the pairs trading strategy in the FX, market prices from 2010 to 2014 of the
9 most liquid pairs were used (EUR/USD, GBP/USD, USD/JPY, CHF/USD,
40
AUD/USD, NZD/USD, CAD/USD, EUR/GBP and EUR/JPY), in a 7-day per week
basis from OANDA Corporation6.
We consider necessary to briefly describe statistically the performance of the

currency pairs separately. Furthermore, we analyze this statistics and state the main
assumptions to support the results of our strategy.
[Graph 4]: Plot of EUR/USD exchange rates

Source: own elaboration
Graph 4 above presents the relationship between the amount of US dollars that
needs to be paid to purchase one unit of Euros. As it can be observed (graphically) the
performance of the currency pairs tend to follow a random walk. It is possible then to
say that they can be broken down by at least two components: a deterministic
component and a stationary component. The first can be linked to the trend, while the
second could be associated with the noisy movements during those trend periods.
6
OANDA uses innovative computer and financial technology to provide Internet-based forex trading and
currency information services to everyone, from individuals to large corporations, from portfolio
managers to financial institutions. OANDA is a market maker and a trusted source for currency data. It
has access to one of the world's largest historical, high frequency, filtered currency databases.
www.oanda.com/corp/
41
Additionally, it is clear that the exchange rate time series do not bahave as a white noise,
which makes it difficult to forecast the prices in the futures. Nevertheless, when the
difference of the logarithm of the prices was calculated (that represent the returns
compounded in continuous time), as it can be seen in the next graph (Graph 5), the
outlook changes. It is clearer than the plot of the prices, because the returns show a
closer performance to a completely stationary (white noise) comportment. In other
words, the returns stay between certain boundaries (not constant through time) and move
around a mean which is close to zero7.
[Graph 5]: Plot of daily returns and histogram of returns (EURUSD)

The second part of Graph 5 presents a comparison of the distribution of the

returns with the Normal Distribution (ND), and it is observable that the tails of the
returns distribution are fatter than the ND. Furthermore, the concentration around the
mean seems to be higher than the ND, so it presents a leptokurtic shape. Another
7
From the theory of International Capital Markets this mean value can not be statistically rejected from
the zero mean hypothesis.
42
important fact is, that there is a slightly negative skewness of the distribution, meaning
that the left side of the returns (the drops in price) is not equal to the right side of the
returns (up-movements in price)
Stand. Ex.
FX rates Min. Median Mean Max Skewness
Dev Kurt.
EURUSD -0,0185 0,0001 -0,00010 0,0195 0,0041 1,7728 -0,2229
GBPUSD -0,0184 -0,0001 -0,00002 0,0148 0,0034 1,7872 -0,2625
USDJPY -0,0218 0,0001 0,00020 0,0275 0,0042 5,6722 0,6178
CHFUSD -0,0453 0,0001 0,00004 0,0245 0,0046 12,744 -1,0777
AUDUSD -0,03421 -0,0001 -0,00004 0,0238 0,0052 2,8631 -0,3715
NZDUSD -0,0366 0,0001 0,00004 0,0215 0,0054 2,4551 -0,4035
CADUSD -0,0237 0,0001 -0,00005 0,0174 0,0037 2,5169 -0,351
EURGBP -0,015 -0,0001 -0,00010 0,0170 0,0033 1,6583 -0,1587
EURJPY -0,0302 -0,0001 0,00010 0,0356 0,0054 4,5269 0,1187
[Table 5]: Descriptive Statistics of Exchange Rates

Table 5 depicts the main statistics measurements of the exchange rates, which
confirms what was stated in the previous paragraphs, namely that the means are close to
zero, and that the Excess Kurtosis (which measures how much is the kurtosis above the
normal distributions that is 3) for all of them is over the Normal Distribution value.
Although one is more than others, for example, the CHF/USD presents around 12 points
over the normal value, and if the skewness is observed, most of them show a negative
result, while just two of them have a slightly positive skewness.
This short analysis of the descriptive statistics of the exchange rates leads us to
conclude that a normal distribution of the returns is not quite accurate. However, the
most common model that is assumed for asset price movements is the log-normal
process, which brings certain implications that are just mentioned without entering in
much detail. First, the logarithms of the prices are a martingale, which means that the
best forecast for a period ahead of a given security is the todays price. Second,
43
differencing the random walk yields to a white noise (as we saw in the (Graph 5), and
this implies at the same time that the autocorrelation is insignificant, which supports the
white noise structure.
3.3 Algorithm Construction
To test the Pairs Trading Strategy, the RSTUDIO program was used. An algorithm was
created that: first, downloads the data, calculates the logarithm of the prices of the
selected exchange rates, and then finds the pairs tradable. The co-integration approach
was applied for a period of 180 days (different rolling window periods) and different
tradable pairs were used in each window. An evaluation of the strategy was performed,
and the returns of each transaction were calculated. Finally, the statistical significance of
the results was tested.
3.3.1 Tradability of the Pairs
After the data was extracted and the returns were calculated (expressed by the first
difference of the logarithm of the prices), the co-integration approach was implemented
to test for the perfect partners (pairs), but only after the spread calculation was done. It
was necessary to run all the different combinations of various pairs by taking into
consideration that the order is important. For example, the residuals were calculated
from the EUR/USD taken as independent variable against the GBP/USD as the
dependent variable, and the vice versa. In general, one of the pairs may return mean
reverting residuals and the other one may not. This probability required us to test the 72
possible combinations of nine exchange rate pairs.
3.3.2 Rolling Window
The experimental approach described in this paper did not evaluate the pairs trading
strategy only once during the whole period, but considered different rolling window
44
periods. The intensity of these tests was made for several reasons. First, exchange rates
do not experience the co-integration for long periods of time. This fact reduces the
number of co-integrated pairs, which consequently decreases the trading opportunities in
the short run. Second, there might be a biased conclusion by the authors of this paper,
since the lack of sufficient statistical information prevents the statistical prove of the
results.
The solution to the problems just mentioned was found by applying the Rolling
Window analysis (depicted in Graph 6). The process consists of selecting the window
size (period), where the co-integration approach is applied to obtain the currency pairs
co-movements during this specific period. Furthermore, this process was implemented
every 30 days until the end of the extracted data was reached.
[GRAPH 6]: The Rolling Window

3.3.3 Trading Opportunities
The final part of the algorithm consists of searching for any trading opportunity within
the 180 days window that triggered the strategy. As it was explained above, the trade
simply consists of taking two opposite positions in both pairs (partners) each time the
upper/lower bounds are exceeded, occurrence which is considered as divergence. If there
was an activation of the strategy, the pairs positions were closed when there was a mean
45
reversion of the spread, considered as convergence, or at the last trading day, whichever
occurs first. Once a trading position was closed, the algorithm started to search for new
trading opportunities from that closing day location onwards, and so on until the last day
of the window has been reached.
Graph 7 shows an example of the strategy. Here it can be observed that during a
period of 52 (first vertical green line, from left to right), the strategy was activated. In
this case a trader could buy the spread (resulting in a Long position in the dependent
variant (NZDUSD), and a short position in the independent variant (EURUSD). The
transaction is closed at the 75th day (the second vertical green line in Graph 7), when the
spread converged to its mean.
Each time that the strategy was activated, the return from the entry day of the
transactions until the closing day was calculated (which could be the convergence day or
the last day of the window). Because the transactions holding periods would differ, it is
necessary to use a standard, which in our case was set to be the conversion of the return
results using a monthly basis.
[Graph 7]: Example of the pairs trading strategy

46
3.3.4 Testing the Results
Finally, after collecting all the returns from each window, two different tests were run to
confirm that the average return of the strategy was statistically significant. First, the
well-known t-test with the hypothesis zero (the mean value is zero), and the alternative
hypothesis which states that the true mean of the returns is greater than zero. Second,
the bootstrapping technic was applied (Efron, 1979), which consists of a random
sampling with replacement method to approximate the distribution function of the
observed data. In order to define the intervals, a 95% confidence level was used, since it
explains where the mean return of the strategy is.
47
Chapter 4: Summary and Results
of the Empirical Analysis
In this chapter we proceed to present the results, step by step, of our empirical approach
to the Pairs Trading Strategy in the FX Market, and with this we try to solve the main
query of this project: Does Simple Pairs Trading Strategy works in the FOREX Market?
We run every part of the algorithm as was explained with a database of the 9 exchange
rates, for around 1800 days. The algorithm, as was explained above, examined the whole
database, looking for co-integrated pairs in periods of 180 days, and moving the window
30 days until the complete database is analyzed, this process was executed 55 times,
which was the number of windows needed to completely cover the database.
N X1 X2 p-value
1 EUR/USD AUD/USD 0,0100 0,3705 0,9766
2 AUD/USD EUR/USD 0,0101 -0,3160 0,7763
3 CAD/USD EUR/USD 0,0481 -0,1047 0,2876
4 CAD/USD GBP/USD 0,0445 -0,1284 0,2355
5 CAD/USD EUR/JPY 0,0248 -1,2448 0,2552
6 EUR/JPY AUD/USD 0,0265 4,8892 1,1330
7 EUR/JPY CAD/USD 0,0100 4,8338 2,4898
[Table 6]: Example of Co-integrated Pairs (window 3)
Table 6 above shows one of the results from the co-integration test in one of the
windows. In this case it is window 3 (which includes the period from the 60th day to the
240th day of the whole sample). It can be further indicated that during this period, seven
currency pairs were co-integrated. The first column represents the exchange rate, which
is considered the dependent variant in the linear regression, and the second column the
exchange rate that is the independent. The following column exposes the p-value
resulting from the augmented Dick-Fuller test. The way to read it is as follows: if the p-
48
value is below 0.05, the residuals time series observed from the linear regression of X1
vs. X2 are mean reverting.
The represents the mean of the spread, which was expected to revert in case
there was a divergence from the usual performance (which is denoted from the linear
regression as the intercept point), and is the co-integrated coefficient that provides the
relation between pairs, and further gives the proportion of the transactions in both
exchange rates. For example, the first pair in Table 6 establishes a relationship of the co-
movement between the EUR/USD and the AUD/USD. If the strategy is activated and
the spread is traded (short in EUR/USD and long in AUD/USD), then for a unit of the
short position in the EUR/USD, 0,9766 in the long position of the AUD/USD must be
taken. The table above comprises the result of a filtering process from the 72
combinations that truly present a mean reversion spread.
[GRAPH 8]: Example of trading opportunities in the strategy

49
The next step in the strategy is to look over the trading opportunities for each of
the co-integrated exchange rates found. Graph 8 illustrates an example of the first pair
in the Table 6 (EURUSD ~ AUDUSD). It can be noticed that the spread performance is
mean reverting. It moves between the two boundaries (the red lines), and each time it
reaches one or the other, there is a convergence to the mean (the horizontal black line).
The first transaction was opened on the first day of the window, because the price
was over the upper bound, therefore the strategy states that the spread should be sold as
follows: taking a short position in the EUR/USD and a long position in the AUD/USD
(0.9766 for each unit of EUR/USD). The position is closed at the 37th day, when the
spread returns to the mean, which resulted in a monthly return of this transaction of
3,36%. Thereafter, the algorithm started to search again for more transactions and found
that in the 76th day the lower bound is exceeded, which means that the spread must be
purchased by taking a long position in EUR/USD and a short position in the AUD/USD
(holding the proportions explained earlier). The transaction is closed on day 81 and the
return from this transaction appeared to be more than 40% monthly. Even though it
looks a lot, this is because the transaction lasted just five days. Lastly, there was one
more transaction on day 83, where the upper bound was exceeded one more time, and
the reversion to the mean occurred on day 90. The monthly return for the period was
18.01%, which again, is high compared with the first transaction, because the transaction
lasted only 7 days. To conclude this example, three transactions with an average
monthly return of 20% were performed, which apparently indicates that the strategy
worked perfectly.
Now, let us take a look to the results when analyzing all the windows, and
consequently all the co-integrated pairs that were found. Graph 9 exhibits all the returns
obtained for the entire period analyzed. Beside this plot, a histogram of these returns was
presented, where we can notice the positive skewness. This provides the information to
suggest that the divergences from the usual behavior of the market (inefficiencies)
50
represent opportunities to exploit the market with the strategy proposed. Additionally,
the fatter right-tail implies that the expected returns from the strategy will be positive.
[Graph 9]: Returns of the pairs trading strategy

After calculating the returns of the strategy, a mean monthly return of 6.21% was
obtained. Nonetheless, it was necessary to test whether this value was or was not
statistically significant. This was done by applying two proper tests in order to examine
the outcome obtained. Thus the observed data was evaluated using a one-sample t-test
and the bootstrapping method. Regarding the first one, the hypothesis zero states: the
mean of the sample is zero, and the alternative hypothesis states that the true mean was
greater than zero. The conclusion was that the mean is greater than zero with a p-value
of 2,2e-16, which provided a high level of confidence interval in the result.
In addition, the bootstrapping method was applied to approach the empirical

distribution of the results in order to obtain the true mean as well as its confidence
interval level. The process was executed with 999 replacements, which increased the
relevance of the results. Graph 10 below shows the results, where the mean is actually
51
6.21%, with a standard error of 0.0033, and an interval at a 95% level of confidence
(0.0556, 0.0687).
[Graph 10]: The Bootstrapping Method in the pairs trading strategy

Ultimately, to summarize the results of the experimental approach for the Simple
Trading Strategy in the FX market, it can be affirmed that after a detailed analysis of the
results, there is some evidence that there exist inefficiencies in the market and it is
possible to exploit them using a market neutral strategy. The expected monthly return
could be between 5.56% and 6.87%. Although its not a zero-risk strategy, as it can be
seen in the plot of the returns, the positive skeweness provides good expectations and
optimistic outcomes for the strategy designed.
52
Conclusions and
recommendations
Conclusions
This project has analyzed the implementation of a simple pairs trading strategy in the FX
market based on the idea that, within an efficient market, there are some cases where
inefficiencies appear, but in the short-run they would be corrected. This is why the
performance of co-integrated time series of the exchange rates was examined with the
purpose to find evidence that there exist opportunities to exploit the inefficiencies in the
market. Then, a market neutral strategy that combined two assets was employed to look
for divergences from their regular behavior. This regular behavior was described
through the construction of a spread between the pairs, which had to present mean
reversion to be considered as tradable.
Our research indicates that there are reasonable amount of co-integrated pairs
throughout the sample, although they do not hold for long periods of time. Hence, the
windows analysis was implemented to find co-movements in shorter time frames. This is
important to be stated, since the number of co-integrated pairs was not always the same.
It was possible to find none or more than 15 co-integrated pairs in a particular window.
Aside the existence of co-integrated time series, it was also found that there exist
divergences (ergo, inefficiencies) from their usual behavior that are corrected in the
short run. In turn, the returns of the trades taken due to the inefficiencies observed
showed promising results; around 6.2% of monthly returns on average do not look less
attractive compared to other investment opportunities nowadays.
53
Recommendations
An extension of this research can be focused on the performance of the strategy in an

out-of-the sample stage. Until now, the results support the premise that the FX market
exhibits short-run inefficiencies that can be exploited using a market neutral strategy
(specifically for this project: a simple pairs trading strategy). The subsequent step would
be to analyze whether it is possible to achieve positive results out of the sample by using
in-sample calculated estimators.
Another substantial field that can be developed for future research is the
frequency of the data. This research was focused on daily prices; however, by increasing
the frequency of the data (for instance, hourly prices) it would be possible to find more
opportunities due to shorter co-integration periods. Furthermore, the exposure to
fundamental events can be reduced, which sometimes is the cause of the breakdown of
the long term relationship between two time series.
54
Bibliography
[1] Bank for International Settlements, Monetary and Economic Department September
2013, Triennial Central Bank Survey, Foreign exchange turnover in April 2013:
preliminary global results
[2] Chen, H. J., Chen, S. J., & Li, F. (2012). Empirical investigation of an equity pairs
trading strategy.
[3] Do, B., Faff, R., & Hamza, K. (2006, May). A new approach to modeling and
estimation for pairs trading. In Proceedings of 2006 Financial Management Association
European Conference.
[4] Do, Binh & Faff, Robert 2010, Does simple pairs trading still works, Financial
analysts Journal, vol.66, no.4, p. 1-14, 83-95.
[5] Efron, B. (1979). Bootstrap methods: another look at the jackknife. The annals of
Statistics, p. 1-26.
[6] Engle, R. F., & Granger, C. W. (1987). Co-integration and error correction:
representation, estimation, and testing. Econometrica: journal of the Econometric
Society, 251-276.
[7] Fuller, W. A. (1976). Introduction to Statistical Time Series. New York: John Wiley
and Sons.
[8] Gatev, E., Goetzmann, W., Rouwenhorst, K. 2014, Pairs Trading: Performance of
a Relative-Value Arbitrage Rule, Oxford.
[9] Georgios ,K (2013). Pairs trading in forex markets: A test of the cointegration
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approach with the EUR/USD and GBP/USD currency pairs. MBA Thesis. University of
Macedonia.
[10] Gorter, Gesina 2006, Pairs Trading
[11] Jacobs, H., & Weber, M. (2015). On the determinants of pairs trading profitability.
Journal of Financial Markets, 23, 75-97.
[12] Jegadeesh, N., & Titman, S. (1993). Returns to buying winners and selling losers:
Implications for stock market efficiency. The Journal of finance, 48(1), 65-91.
[13] Lin, Y. X., McCrae, M., & Gulati, C. M. (1998). Cointegration between exchange
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SSRN: http://ssrn.com/abstract=1911068 or http://dx.doi.org/10.2139/ssrn.1911068
[15] PFG Best , Foreign Exchange Basics, Available from:

http://www.pfgbest.com/services/forex/foreignexchangebasics.pdf , [9 June, 2015]
[16] Stock, J. H., & Watson, M. W. (1988). Testing for common trends. Journal of the
American statistical Association, 83(404), 1097-1107.
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Methods and Analysis by Ganapathy Vidyamurthy.
[19] Zhang, M. 2012, Research on Modern Implications of Pairs Trading, University of

California, Berkeley.
56
Appendixes
Tables
Table 1: Major currencies in global trade ............................................................ 9
Table 2: Global Foreign Exchange market Turnover (1998-2013) ....................... 15
Table 3: Currency Distribution of global foreign exchange market turnover ......... 16
Table 4: Empirical Results of the strategy (July 1963 December 2002) ............ 26
Table 5: Descriptive Statistics of Exchange Rates............................................... 43
Table 6: Example of Co-integrated Pairs (window 3) ........................................... 48
Graphs
Graph 1: FX turnover by counterparty ................................................................. 17
Graph 2: FX turnover by traded instrument ......................................................... 17
Graph 3: Pairs Trading Strategy with normalized returns .................................... 25
Graph 4: Plot of EUR/USD exchange rates ......................................................... 41
Graph 5: Plot of daily returns and histogram of returns (EURUSD) ..................... 42
Graph 6: The Rolling Window ............................................................................. 45
Graph 7: Example of the pairs trading strategy ................................................... 46
Graph 8: Example of trading opportunities in the strategy ................................... 49
Graph 9: Returns of the pairs trading strategy ..................................................... 51
Graph 10: The Bootstrapping Method in pairs trading strategy............................ 52
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Master in Finance & Banking

DOES SIMPLE PAIR TRADING WORK IN

Cristhian Vesga Bermejo1

Key words: Pairs trading, market neutral, co-integration, exchange rates.

When Pairs Trading Strategy is considered, it is referred as a statistical arbitrage

The objective of this project is to show, empirically, the evidence of any

However, the literature of Pairs Trading, generally speaking, has significant

Currency traders could perform operations through a centralized exchange. The

OTC market is known as a secondary market. It was developed more recently

The FX market allows traders to respond immediately to currency fluctuations

1.2 Major currencies

[TABLE 1]: Major Currencies in global trade

1.3 Quotation of the currencies

In our previous example, if the pair is quoted as 2.4563/2.4565, it means that a

1.4 Setting a trading position

A trading account is established by providing a margin deposit, a deposit hold by

Another term in currency trading is the margin call. It represents an involuntary

1.5 History and Characteristics of the Market

When a FX position is considered, a trader is long in one currency and short in

1.6 FOREX Turnover

1.6.1 Turnover of currencies and different currency pairs

[Table 2]: Global Foreign Exchange market Turnover (1998-2013), in $Billions

1.6.2 Turnover of currencies by counterparty

[Graph 2]: FX turnover by traded instrument

1.7.1 Fundamental Analysis

Fundamental analysis is heavily used in equity examination to measure a companys true

1.7.2 Technical Analysis

Technical analysis is used by market participants in order to forecast price movements

1.7.3 Quantitative Analysis

Quantitative analyses are based on computational statistics. Such examination is used to

Quantitative trading includes high frequency transactions, algorithmic trading,

Pairs trading, also referred to as statistical arbitrage by researchers, is a trading

2.2 The Distance Method

Even though pair trading is considered to be an arbitrage strategy, it could not be

[Graph 3] Pairs Trading Strategy with normalized returns (August 1963 -

2.4 Importance of co-integration in the strategy

Other examples of co-integration could be considered the following:

Income-consumption relationship: when income increases, so does consumption.

So why is co-integration so important? It is assumed that in quantitative finance

Why is it necessary to use the concept of co-integration, when there is possibility

The concept of correlation is used by practitioners in testing co-movements of

2.4.2 The Concept of the Common Trend Co-integration Model

The innovation sequences should be perfectly correlated in a co-integrated system

The innovation sequence of a random walk is defined by differentiating it ( ).

The co-integration coefficient could be defined with the following formula:

2.4.3 Necessary conditions for co-integration

Having provided information of the model, let us observe how it is applied in

2.6 Summary of the common trend model

The mean of the observation does not change in time

3.1 Application of the strategy

It is important to answer the question of why we rely only on the second

Consequently, if any transaction is activated we compute the return between the

3.2 Data collection and statistical analysis

We consider necessary to briefly describe statistically the performance of the

[Graph 4]: Plot of EUR/USD exchange rates

[Graph 5]: Plot of daily returns and histogram of returns (EURUSD)

The second part of Graph 5 presents a comparison of the distribution of the

[Table 5]: Descriptive Statistics of Exchange Rates

3.3 Algorithm Construction

3.3.1 Tradability of the Pairs

3.3.2 Rolling Window

[GRAPH 6]: The Rolling Window

3.3.3 Trading Opportunities