Pair Trading in Tehran Stock Exchange based on Smooth Transition GARCH Model

Document Type: Original Article

Authors

1 Assistant Professor of Finance, Faculty of Management, University of Tehran, Iran. corresponding author

2 2. Assistant Professor of Finance, Faculty of Management, University of Tehran, Iran.

3 Master of Finance, University of Tehran, Tehran, Iran.

Abstract

In this research, we use a pair trading strategy to make a profit in an emerging market. This is a statistical arbitrage strategy used for similar assets with dissimilar valuations. In the present study, smooth transition heteroskedastic models are used with the second-order logistic function for producing thresholds as trading entry and exit signals. For generating upper and lower bounds, we apply the rolling window approach and one-step-ahead quantile forecasting. Markov chain Monte Carlo sampling method is used for optimizing the parameters. Also, passive strategy in the out-of-sample period is used to compare the profits. The population consists of 36 daily stock returns in Tehran Stock Exchange. Then, we select ten pairs from these stocks and use Minimum Square Distance method, and five pairs from one industrial sector. Finally, we see strategy1 and 2 have positive returns in the out-of-sample period, and they produce higher returns than passive strategy.

Keywords