1. Pairs Trading Analysis Global Asset Allocation Spring 2004 The Hemline Theorists

2. Pairs Trading Analysis Introduction Introduction Developing the Model Developing the Model Results Results

3. Introduction Long/short, market- and industry- neutral strategy Long/short, market- and industry- neutral strategy Pair selection criteria: Pair selection criteria: same industrysame industry mature companiesmature companies long trading historieslong trading histories similar exposure to macro factorssimilar exposure to macro factors Assume reversion to historical value relationships Assume reversion to historical value relationships

4. Developing the Model Variable selection Variable selection Stock price ratioStock price ratio Dividend yield ratioDividend yield ratio Selecting in-sample period and data frequency Selecting in-sample period and data frequency Daily data: 1987-2004 Daily data: 1987-2004

5. Pairs Trading Analysis: Model Parameters Variables Switched on or off Variables Switched on or off Deviation from mean historical ratio required for trade signal Deviation from mean historical ratio required for trade signal Translation of individual variable trade signals into overall trade signal Translation of individual variable trade signals into overall trade signal

6. Selecting Pairs – Ford and GM Ford announces highest earnings in auto industry history GM introduces its "GM10" family of newly redesigned midsize cars. Restores profitability through streamlined operations. GM announces a restructuring of its North American sales and marketing operations, replacing marketing division-specific organizations with a single sales

7. Model Demonstration

8. In-Sample Optimization Find the model parameters that: Find the model parameters that: Maximize average annual return on trade daysMaximize average annual return on trade days Trade on at least 10% of total daysTrade on at least 10% of total days Limit maximum drawdown to 15%Limit maximum drawdown to 15% Sanity check to ensure model works over time and is currently validSanity check to ensure model works over time and is currently valid

9. Model Parameters

10. In-Sample Results

11. Out-of-Sample Results

12. Extending the Model to Other Pairs Eli Lilly & Merck Coca-Cola & Pepsi

13. Pairs Trading Analysis Questions? Questions?

14. In Sample Optimization