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STAT 434 Rebecca Wu Troy Shu Final Report

STAT 434 Rebecca Wu Troy Shu Final Report

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Published by: tmshu1 on Dec 22, 2012
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UNIVERSITY OF PENNSYLVANIA
Statistical Pair Trading onInternational ETFs
Rebecca WuTroy Shu
STAT 434 Final Project ReportSteele
 
December 18, 2012
 
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I. Executive Summary
Pair trading international ETFs with a non-adaptive strategy does not seem to performwell over longer time frames due to the changing dynamics of mean reversion and momentum ininternational ETFs. However, after applying an adaptive “filter” to our pair trading strategy, ourreturns improved dramatically which suggests that being able to successfully capture these meanreversion and momentum dynamic changes can be profitable.Our first step was to conduct exploratory data analysis on the price and return data for 22international ETFs. We did not find anything out of the ordinary: the international ETF prices arehighly autocorrelated, not normally distributed and not stationary while the ETF returns areautocorrelated, heavy-tailed and stationary.Next, we backtested our international ETF pair trading strategy. Our strategy used theAugmented Dickey-Fuller stationarity test to select only the cointegrated ETF pairs as potentialtrades.After regressing the price of one ETF against the price of the other over a rolling 120-dayformation period, our strategy then ordered the ETF pairs by the magnitude of the currentresidual on the 120
th
day and selected the top 5 ETF pairs with the largest residual/divergence totrade for the next 20 days.Initial results were poor: the strategy produced a full period Sharpe Ratio of -0.16 and amax drawdown of -53.3%. Plotting the rolling Sharpe Ratios showed that they oscillated around0.00,so the overall risk-reward relationship of our initial strategy remained poor throughout time.We considered using a GARCH(1,1) model to obtain a clearer picture of the standard deviationof our strategy returns, and thus a clearer picture of the rolling Sharpe Ratio. However, the factthat the residuals of our strategy’s returns are heavy-tailed precluded the use of GARCH tomodel the standard deviation of our strategy’s returns. We also conduct an analysis usingdifferent Kelly criterion bets and as expected, our strategy’s terminal wealth and compoundannualized growth rate is higher than the strategy that does not use Kelly bets.In looking for ways to improve our initial international pairs trading ETF strategy, wenoticed that there seemed to be “regime shifts” over time between the dominance of meanreversion or momentum in the returns of the ETFs. We applied a moving average “filter” to theinitial trading strategy to reverse the international ETF pair trades in the correct direction when it
 
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seemed that these regime shifts occurred. Our pair trading strategy’s returns improveddramatically, producing a full period Sharpe Ratio close to 1 and a max drawdown of -35%.
II. Premise: Pairs Trading on International ETFsPaper
We decided to base our project on the premise of the quantitative financial research papertitled “Pairs Trading on International ETFs”, authored by Schizas, Thomakos, and Wang. In theirpaper, Schizas and his colleagues developed an international ETFs pair trading strategy thatproduced spectacular results but did not seem to have a strong statistical foundation.The authors of the paper used 23 international ETFs, representing countries such as theUSA, Germany, Brazil, Japan, and even smaller countries like Belgium and Malaysia. Theauthors implemented their backtest using a rolling window: They had a 120-day formationperiod in which they ranked all pairs of international ETFs and selected the top five to trade in asimple 1-to-1 ratio. Then they had a 20-day trading period in which they calculated the ex-postreturns of the ETF pairs that they selected in the formation period. Rolling these two windowsforward together by 20 days produced ex-post returns for another 20 days.To order the ETF pairs, the authors used the average absolute difference between thecumulative returns of two ETFs starting from the beginning of the 120-day formation period. Indoing so, they were essentially betting that two international ETFs whose prices have shown todiverge a lot will tend to converge in the future. However, they did not offereither a fundamentaleconomic reason or statistical evidence to explain such convergence behavior.When assessing the performance of their strategy, theauthors neglected to provide basicperformance metrics such as monthly return, compound annualized growth rate, or maxdrawdown numbers for their strategy. They only provided a single bar chart of monthly returnsand a few equity curves that are depicted below.

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