Pari Trading: How to determine the correct Hedge Ratio with FX

Let's say I want to pair trade the following USD based FX :

XXX/USD

YYY/USD

The pairs have these price time series:

XXX/USD: (13, 15,14, 16, 15, 17,16, 19, 20)

YYY/USD: (3, 4, 3, 4, 5, 4, 6, 5, 6)

Let's assume that YYY/USD is the more independent variable and run the linear regression in R:

lm(XXX/USD~YYY/USD)

https://preview.redd.it/p3s3pykpg2u51.png?width=905&format=png&auto=webp&s=194c0b1d9f4a15d1719331691a85a0cd8cb060fb

Result:

Coefficients:

(Intercept) YYY/USD

9.783 1.424

I use zScore of the price ratio to define entry/exit points.

I think I now have two choices: Make a Dollar neutral pair trade (buy/sell 100 USD of each instrument)

Or I can make a beta neutral trade which is I guess buy/sell an unequal dollar amount of those instruments according to the beta factor 1.42 => is that correct ?

But if yes, the latter I simply don't get how to calculate the positions using the factor.

E.g.: YYY/USD is 6, XXX/USD is 20.In a Dollar neutral strategy I would e.g. buy 16.66 YYY/USD and sell 5 XXX/USD (not sure if that is 100% correct now…).

In a beta neutral strategy…?

Or are my basic assumptions wrong?

Submitted October 19, 2020 at 09:12AM by flotschie
via https://ift.tt/35a5RKU

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