Chapter 2: FAQs 69
This is clearly easier than using all 500 stocks for the
tracking (when, of course, the tracking error would be
zero).
We don’t have to track the index, we could track any-
thing we want, such ase^0.^2 tto choose a portfolio that
gets a 20% return. We could analyze the cointegration
properties of two related stocks, Nike and Reebok, for
example, to look for relationships. This would be pairs
trading. Clearly there are similarities with MPT and
CAPM in concepts such as means and standard devi-
ations. The important difference is that cointegration
assumes far fewer properties for the individual time
series. Most importantly, volatility and correlation do
not appear explicitly.
Another feature of cointegration isGranger causality
which is where one variable leads and another lags.
This is of help in explaining why there is any dynamic
relationship between several financial quantities.
References and Further Reading
Alexander, CO 2001Market Models. John Wiley & Sons
Engle, R & Granger, C 1987 Cointegration and error correction:
representation, estimation and testing.Econometrica 55
251–276
