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A Regime-Switching Relative Value Arbitrage Rule

Last Updated on 10 February, 2024 by Rejaul Karim

Embarking on the frontier of financial innovation, Michael Bock and Roland Mestel present a succinct yet potent exploration in “A Regime-Switching Relative Value Arbitrage Rule.” Unfolding across six pages, this intellectual journey, crafted in August 2008, converges the realms of statistical arbitrage and pairs trading.

At its core, the relative value arbitrage rule, a venerable strategy, finds new dimensions through the lens of Markov regime-switching. As mispricing dances between equilibrium and deviation, this novel approach discerns not just transient fluctuations but also enduring deviations from spread equilibrium.

The interplay of mean reversion and Markov regime-switching paints a nuanced landscape for speculative prowess, breathing fresh life into a strategy with roots tracing back to the financial annals of the 1980s.

Abstract Of Paper

The relative value arbitrage rule (“pairs trading”) is a well-established speculative investment strategy on financial markets, dating back to the 1980s. Based on relative mispricing between a pair of stocks, pairs trading strategies create excess returns if the spread between two normally comoving stocks is away from its equilibrium path and is assumed to be mean reverting. To overcome the problem of detecting temporary in contrast to longer lasting deviations from spread equilibrium, this paper bridges the literature on Markov regime-switching and the scientific work on statistical arbitrage.

Original paper – Download PDF

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Author

Michael Bock
University of Graz

Roland Mestel
University of Graz

Conclusion

In conclusion, this study introduces a compelling advancement in the realm of speculative investment strategies by merging the well-established relative value arbitrage rule with the insights from Markov regime-switching.

Pioneering a regime-switching relative value arbitrage rule, the paper addresses the challenge of distinguishing between temporary and more enduring deviations from spread equilibrium. By leveraging the dynamics of Markov regime-switching, the strategy adds a nuanced layer to traditional pairs trading, enhancing its adaptability to evolving market conditions.

The synthesis of statistical arbitrage principles with regime-switching dynamics provides a novel perspective, offering potential avenues for more robust and responsive investment strategies in the complex landscape of financial markets.

Related Reading:

A Pairs Trading Strategy Based on Mixed Copulas

When Two Anomalies Meet: The Post-Earnings Announcement Drift and the Value-Glamour Anomaly

FAQ

Q1: What is the central concept explored in “A Regime-Switching Relative Value Arbitrage Rule” by Michael Bock and Roland Mestel?
A1: The paper introduces a regime-switching relative value arbitrage rule, merging the well-established relative value arbitrage (pairs trading) strategy with insights from Markov regime-switching. This innovative approach aims to address the challenge of distinguishing between temporary and more enduring deviations from spread equilibrium in financial markets.

Q2: How does the regime-switching relative value arbitrage rule enhance traditional pairs trading strategies?
A2: By leveraging the dynamics of Markov regime-switching, the regime-switching relative value arbitrage rule adds a nuanced layer to traditional pairs trading. It provides a more sophisticated mechanism for discerning not only transient fluctuations but also enduring deviations from spread equilibrium. This enhancement contributes to the strategy’s adaptability to evolving market conditions.

Q3: What potential benefits does the synthesis of statistical arbitrage principles with regime-switching dynamics offer to speculative investment strategies?
A3: The synthesis of statistical arbitrage principles with regime-switching dynamics offers a novel perspective, potentially providing more robust and responsive investment strategies in the complex landscape of financial markets. This advancement aims to improve the ability to navigate market dynamics by incorporating the regime-switching element into the well-established relative value arbitrage rule.

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