Cointegration of price series explained
Question
What does it mean for two or more time series to be cointegrated?
Short answer
Non-stationary series are cointegrated if some linear combination of them is stationary. Each series may wander like a random walk, but a particular weighted spread keeps reverting to a mean, so they share a long-run equilibrium. This underlies pairs trading and index tracking; it is tested with Engle-Granger (regress, then test residuals for a unit root) or Johansen, and it is a different notion from correlation of returns.
Adapted from Wilmott, Frequently Asked Questions in Quantitative Finance, FAQ 13, p.67; question and answer rewritten by SelfMadeQuant.com.
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- Populations, Samples, and Sampling Distributions
- Series and the Geometric Series: Partial Sums and Convergence
- The Fundamental Theorem of Calculus
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