Searching "Nice" Pairs for Market Neutral Investments

Abstract

Forecasting stock price in level is very difficult because such a series is often described as an integrated process. In spite of that, a linear combination of two stock prices can be stationary around a fixed mean. Then taking both long and short position can lead to profit. This article aims to characterize the long-short strategies based on cointegration by investigating their risk-return properties. We propose a framework of long-short trading system based on cointegration analysis, and define two trading strategies, a contrarian type and a momentum type strategy. We consider some restrictions on investment choices by sector and by firm size. The aim of this article is to investigate how such restrictions affect the risk-return properties of the hypothetical long-short funds.