Optimal hedging using cointegration

Cointegration is a time-series modelling methodology that has many applications to financial markets. When spreads are mean reverting, prices are cointegrated. Then a multivariate model will provide further insight, into the price equilibria and returns causalities within the system. Spot-futures arbitrage, yield curve modelling, index tracking and spread trading are some of the applications of cointegration that are reviewed in this paper. With the demand for new quantitative approaches to active investment management strategies there is considerable interest in cointegration theory. This paper presents a model of cointegrated international equity portfolios which is currently used for hedging within the European, Asian and Far East countries.