Linear Equation

AI & Machine learning
1

Hi



In E Chan course for Pair trading, he is using linear equation through the Orgin(X=0,Y=0) to get hedge ratio and further calculations. I am wordering why through the Orgin was selected and not Linear equation with Constant.



Thanks

2

Hi Aparna,

The linear combination is intuitively done to simplify the portfolio value equation. To understand it simply, if 2 correlated assets are seen, in real life if asset A goes to $0 worth, then asset B would also be $0 worth. Hence the origin (0,0) is where the line passes(intercept zero). In case the intercept is non-zero, you need to modify the portfolio value equation and solve accordingly.



Hope this helps!