The Australian and Canadian economies are commodity based and hence their stock markets are cointegrated. However, during periods where Crude Oil volatility is high, cointegration tends to weaken. A stationary portfolio is formed using the 2 ETFs and when the portfolio deviates from its long-term mean opposite positions are taken to invest in the mean reversion of this portfolio to its mean. Kalman filter is used to optimize the strategy with high returns and low volatility
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A stationary portfolio is structured by combining 2 or more financial securities (non-stationary) whose price (net market value) is mean reverting. The strategy is profitable when investor buys the portfolio when it’s value is significantly below its long term mean and sells the portfolio when it’s value is significantly above its long term mean. The strategy’s aim is to capture gains from betting on reversion to the mean.
A Johansen test is run to check for cointegration between the 2 ETFs EWA which represents the Australian Stock Market and EWC representing the Canadian Stock Market. Once Johansen test succeeds in confirming cointegration of 2 assets a potrfolio is structured with hedge ratio calculated from a Kalman Filter. Buying and selling orders are triggered when the porfolio’s value is below its long-term mean or above its long-term mean by more than 1 standard deviation from its long-term mean. Mean-reversion to the mean generates considerable profits