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Mathematically, what is going on here?

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  • $\begingroup$ I think this is a valid question, but you should give us more information before we can comment. $\endgroup$ – David Addison Feb 28 '18 at 1:51
  • $\begingroup$ What additional information would be useful? $\endgroup$ – Liam Donovan Mar 7 '18 at 11:35
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Think of the case, when one time series is a constant equal to zero, and the second time series is stationary. You still can run regression to find the hedge ratio is zero, and you don't need to hedge a stationary price with a constant.

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  • $\begingroup$ So if I have two non-stationary cointegrated series, they must be correlated? That makes sense intuitively, but I don't know if there's a counter-example I'm not thinking of. $\endgroup$ – Liam Donovan Mar 7 '18 at 11:34
  • $\begingroup$ Depends on what you mean by correlated. Mine was just an example, I'm sure it's possible to contrive another example, where both series are non-stationary, but the correlation is pretty low. $\endgroup$ – LazyCat Mar 7 '18 at 16:55
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If two price series are cointegrated, you can run the linear regression to calculate the hedge ratio.

The linear regression is in the form: $$y = \beta X + \epsilon$$

where, $y$ is the dependent variable, $X$ is the independent variables, and $\beta$ is the slope that we want to estimate and $\epsilon$ is the error term.

In Python, the OLS function from the statsmodels package is used to calculate the hedge Ratio:

statsmodels.api.OLS (dependent_variable(y), independent_variable(X))
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