[R-SIG-Finance] Better Hedge Ratios for Spread Trading

[G See]

Paul,

Thank you very much for sending this; I've seen the lightning talk slides,
and spent some time playing with it.  I do have a couple observations.

First, often it seems like if I use the inverse of your code I get better
results.

i.e. I find that r$loadings[1,1] / r$loadings[2,1] is closer to what I get
using other hedge ratio calculation methods.

I attached a hedge ratio calculating function called "btcdHedge" to use as
a comparison.  I took the code for this function from
http://quantivity.wordpress.com/2011/10/02/proxy-cross-hedging/

If I use btcdHedge to calculate the ratio between SPY and DIA since
2011-01-01, it tells me to sell 1.070554 DIA for each share of SPY that I
am long.

That is very close to the 1.070894 I would get if I used  OLS with a zero
intercept

If I use OLS with a floating intercept, I get 1.206745.

If I use your TLS code, I get 0.777546

So, your TLS code is the only one that gives a ratio of less than 1.

However, if I use the inverse of your code I get something close to OLS
with floating intercept
r$loadings[1,1] / r$loadings[2,1]
[1] 1.286098


Second,
You say
"Forcing a zero intercept requires an additional step: recentering the data
around
their means prior to the PCA."

However, I get the same values regardless of whether I center around the
means.

Thanks,
Garrett

On Tue, Nov 29, 2011 at 12:08 PM, Paul Teetor <paulteetor at yahoo.com> wrote:

> R-SIG-Finance community:
>
> I recently posted a short paper entitled Better Hedge Ratios for Spread
> Trading:
>
>    http://www.quanttrader.info/public/betterHedgeRatios.pdf
>
> The topic is pretty arcane but important to spread traders. A surprizing
> number of textbooks and practitioners simply use ordinary least squares
> (OLS) to calculate their hedge ratios, but OLS can give misleading results.
> The paper shows how to use total least squares (TLS) to obtain a better
> balanced spread. The needed R code is simple and included in the paper.
>
> The paper is based on a lightning talk I gave at the R/Finance Conference
> back in April.
>
> I welcome all comments. I can't guarantee I will quickly incorporate your
> feedback into the paper, unfortunately. Heck, it took me seven months just
> to get out this first version.
>
> Paul Teetor
> Elgin, IL   USA
> http://www.linkedin.com/in/paulteetor
>
> "For quant traders, there are no bad days in the market. It's just more
> data."
>
>
>        [[alternative HTML version deleted]]
>
> _______________________________________________
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>
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