Handbook of Finance: Investment Management and Financial Management

Chapter 40. Statistical Arbitrage

BRIAN J. JACOBSEN, PhD, CFA, CFP

Associate Professor of Business Administration, Wisconsin Lutheran College and Chief Economist and Partner, Capital Market Consultants, LLC

Abstract: Statistical arbitrage refers to the use of statistical tools in the discovery and exploitation of market mispricings. If a zero-cost portfolio can be established that has a positive payoff, an arbitrage opportunity exists. Underlying all statistical arbitrage strategies is a model of the price processes of the securities. Statistics allows for the determination of those price processes.

Keywords: statistical arbitrage, correlation trading, pairs trading, cointegration, error correction model, trading strategies, arbitrage, linear regression models, model risk

The mantra of business is "Buy low and sell high." This also applies to investing. If you can simultaneously execute both sides of the transaction—the buying and the selling—without any commitment of capital, you have pure arbitrage (also known as riskless arbitrage). The activity of arbitrage tends to be self-exhausting: Buying the lower-priced good creates demand for it and drives up its price, while selling the higher-priced good increases supply and drives down its price.

Why add "statistical" to arbitrage? This is done because statistical arbitrage relationships are much more prevalent than pure arbitrage opportunities. Statistical arbitrage strategies are based on the idea that we do not know with certainty what ...