What is cointegration in time series and why is it important in financial modeling?

Cointegration occurs when two or more non-stationary series move together and maintain a stable long-term relationship.

Even if individual time series are non-stationary, they may be linked through a stable equilibrium relationship. Cointegration identifies such relationships. If a linear combination of series is stationary, they are cointegrated. This is crucial in finance for pairs trading, where price spreads revert to a mean.