A hidden Markov model for statistical arbitrage in international crude oil futures markets

Paper: arXiv 2309.00875

Authors: Viviana Fanelli, Claudio Fontana, Francesco Rotondi

Abstract

In this work, we study statistical arbitrage strategies in international crude oil futures markets. We analyse strategies that extend classical pairs trading strategies, considering the two benchmark crude oil futures (Brent and WTI) together with the newly introduced Shanghai crude oil futures. We document that the time series of these three futures prices are cointegrated and we model the resulting cointegration spread by a mean-reverting regime-switching process modulated by a hidden Markov chain. By relying on our stochastic model and applying online filter-based parameter estimators, we implement and test a number of statistical arbitrage strategies. Our analysis reveals that statistical arbitrage strategies involving the Shanghai crude oil futures are profitable even under conservative levels of transaction costs and over different time periods. On the contrary, statistical arbitrage strategies involving the three traditional crude oil futures (Brent, WTI, Dubai) do not yield profitable investment opportunities. Our findings suggest that the Shanghai futures, which has already become the benchmark for the Chinese domestic crude oil market, can be a valuable asset for international investors.

Complexity vs Empirical Score

• Math Complexity: 6.5/10
• Empirical Rigor: 7.5/10
• Quadrant: Holy Grail — high math complexity, high empirical rigor

Why this score: The paper presents a mathematically sound approach combining cointegration, regime-switching mean-reversion, and dynamic online HMM filtering for statistical arbitrage. It offers strong empirical relevance by showing viable profitability in the newer Shanghai crude oil futures compared to traditional markets, backed by transaction cost considerations.

Research Flowchart

  flowchart TD
    A[Research Goal: Evaluate Stat-Arb in Crude Oil Futures] --> B[Data Inputs: Brent, WTI, Shanghai & Dubai Futures]
    B --> C[Methodology: Cointegration Analysis & Triplet Spreads]
    C --> D[Model: Hidden Markov Model with Mean-Reverting Regimes]
    D --> E[Computation: Online Filter-Based Parameter Estimation]
    E --> F[Trading Strategy Implementation & Backtesting]
    F --> G[Outcome 1: Shanghai Futures Strategies are Profitable]
    F --> H[Outcome 2: Traditional Futures Brent/WTI/Dubai Unprofitable]