[R-SIG-Finance] Finding Correlation on Spreads

Arun.stat arun.kumar.saha at gmail.com
Tue Jan 25 17:04:37 CET 2011

In most case you might be calculating the correlation between that spread
which is stationary in nature (quite logical to assume the
stability/stationarity of a spread series) with some other price which may
often be realization from some unit root process. In such case you might
think the joint evolution of that bivariate system as a bivariate integrated
VAR process (with the maximum order of integration of that system is 1).
Assuming there is no co-movement exist between them, you need to take just
the 1st difference of the entire system i.e. you are differentiating once
both price and spread series. And estimate the correlation between them from
the estimated VCV matrix of the Residuals.

On the other way, if that spread is not actually just tradable then, you can
think that spread as a portfolio of 2 non-stationary asset series. Hence in
such case you will have a trivariate VAR system with all variables are
non-stationary, unlike the 1st case. Here again you can estimate the
required correlation from estimated VCV matrix (which is of order 3 now)
with little straightforward mathematics.

Hence if you think your problem of estimating correlation from a VAR system
perspective, your problem will become quite simplified.



Arun Kumar Saha, FRM
Visit me at: http://in.linkedin.com/in/ArunFRM
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