Applying Factor Model to Pair Trading

Published on Sep 28, 2023. Pair trading is a market-neutral strategy that involves constructing a long-short portfolio comprising two highly correlated assets. The primary objective of this strategy is to generate profits irrespective of market movements.

While the long-short portfolio effectively mitigates most market risks, there are still certain risks that can be attributed to the factor model. Therefore, it is worth considering whether the utilization of a factor model during the portfolio construction process can enhance market neutrality even further.