FoundationMultiple choice
Two prices that wander together · Part 1 of 3
The log prices of two stocks each look like random walks: unit-root tests cannot reject a unit root in either. You regress one log price on the other in levels over five years of daily data and get an R² of 0.85 and a t-statistic of 25 on the slope.
What should you conclude from the regression alone?
- AVery little, since unrelated random walks often give such numbers
- BA strong relationship, since a t-statistic of 25 is far beyond any critical value
- CThat the pair is cointegrated, because R² is above 0.8
- DThat one stock causes the other
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Unit roots, spurious regression and the basis of pairs trading
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