AppliedMultiple choice
Two prices that wander together · Part 2 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.
How do you test whether the two prices are cointegrated?
- ARun an ADF test on the residuals, comparing with the ordinary Dickey–Fuller critical values
- BRun an ADF test on the residuals, using Engle–Granger critical values
- CRe-run the slope test with Newey–West standard errors
- DTest each price for a unit root again with a longer sample, expecting a rejection
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Unit roots, spurious regression and the basis of pairs trading
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