PAIR TRADING STRATEGY IN INDIAN CAPITAL MARKET: INTRODUCTION(2)

The equalized strategy, in addition to holding stocks long and short in equal dollar balance, adds a permanent stock index futures overlay in an amount equal to the invested capital. The hedge strategy also holds stocks long and short in equal dollar balance but also has a variable equity market exposure based on a market outlook. The variable market exposure is achieved using stock index futures. Do, Faff and Hamza 1(2006) structure the different approaches to long/short equity investing slightly differently to Jacobs and Levy (1993) and, in doing so, attempt to clarify the position of a pairs trading strategy amongst other seemingly related hedge fund strategies.

Do et al (2006) note that due to the strategies’ fundamentals, which involve the simultaneous purchase of undervalued stocks and the shorting of over-valued stocks, pairs trading is essentially a form of long/short equity investing. After consulting academic sources and informal, internet-based sources, they declare that long/short equity strategies can be classified as either market neutral strategies or pairs trading strategies. This interpretation can be reconciled to that proposed by Jacobs and Levy 2 (1993) since all three of their long/short strategies include elements of market neutrality, even if the resulting portfolio may exhibit some market risk.

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