[Solved] FIN5330 Exam 1

• Replicate the pairs trading results in the paper Illuminating the Profitability of Pairs Trading: A Test of the Relative Pricing Efficiency of Markets for Water Utility Stocks.
• Use the historical data in the accompanying file csv.
• Use the BIC criteria for the number of lags to use in all ADF tests. Consider a max number of lags equal to 10.
• Submit your work as either a Jupyter Notebook with Python code or an R Markdown notebook with R code.

Update: March 22, 2019

• I decided that you could take another month trying to get the exact replication of the papers trading strategy implementation. I dont want you to spin your wheels on a lost cause. So here is what I want you to do instead.
• Estimate equation (6) in the paper for each of your pairs. Then form the residuals as outlined (see equations (7) and (8) in the paper).
• Esimate from the estimated residuals.
• Calculate the upper and lower bounds for the trading rules as:

UpperBound = +1.0 _i

LowerBound = 1.0 _i

• for i = {1,2,3} and = {0.25,0.5,0.75} as in the paper.
• Make three time series graphs with the residuals plotted against the upper and lower bounds for each _i.
• Fill in the following table with the number of buy and sell signals for each trading rule:

_i Buy Signals Sell Signals

• Explain what a buy signal and a sell signal means in the context of pairs trading.
• For example, identify the first buy and the first sell signals for the ₁ = 0.25 trading rule and interpret them both qualitatively and quantitatively. How many days is each position held for? What the return on the trade?

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