Performance of Relative Value Arbitrage

Only available on StudyMode
  • Download(s) : 96
  • Published : May 17, 2013
Open Document
Text Preview
Yale ICF Working Paper No. 08­03  First Draft:  June 1998  This Version:  February 2006  Pairs Trading:  Performance of a Relative  Value Arbitrage Rule  Evan Gatev, Boston College  William N. Goetzmann, Yale School of Management, International  Center for Finance  K. Geert Rouwenhorst, Yale School of Management, International  Center for Finance  This paper can be downloaded without charge from the  Social Science Research Network Electronic Paper Collection: 

http://ssrn.com/abstract=141615

Pairs Trading: Performance of a Relative Value Arbitrage Rule Evan Gatev Assistant Professor Boston College William N. Goetzmann Edwin J. Beinecke Professor of Finance and Management Studies Yale University K. Geert Rouwenhorst Professor Yale University

First draft: June 1998 This version: February 2006

Abstract We test a Wall Street investment strategy, “pairs trading,” with daily data over 1962-2002. Stocks are matched into pairs with minimum distance between normalized historical prices. A simple trading rule yields average annualized excess returns of up to 11 percent for selffinancing portfolios of pairs. The profits typically exceed conservative transaction costs estimates. Bootstrap results suggest that the “pairs” effect differs from previously-documented reversal profits. Robustness of the excess returns indicates that pairs trading profits from temporary mis-pricing of close substitutes. We link the profitability to the presence of a common factor in the returns, different from conventional risk measures.

We are grateful to Peter Bossaerts, Michael Cooper, Jon Ingersoll, Ravi Jagannathan, Maureen O’Hara, Carl Schecter and two anonymous referees for many helpful discussions and suggestions on this topic. We thank the International Center for Finance at the Yale School of Management for research support, and the participants in the EFA’99 Meetings, the AFA’2000 Meetings, the Berkeley Program in Finance and the Finance and Economics workshops at Vanderbilt and Wesleyan for their comments.

1

Introduction Wall Street has long been interested in quantitative methods of speculation. One popular short-term speculation strategy is known as “pairs trading.” The strategy has at least a twentyyear history on Wall Street and is among the proprietary "statistical arbitrage" tools currently used by hedge funds as well as investment banks. The concept of pairs trading is disarmingly simple. Find two stocks whose prices have moved together historically. When the spread between them widens, short the winner and buy the loser. If history repeats itself, prices will converge and the arbitrageur will profit. It is hard to believe that such a simple strategy, based solely on past price dynamics and simple contrarian principles, could possibly make money. If the U.S. equity market were efficient at all times, risk-adjusted returns from pairs trading should not be positive. In this paper, we examine the risk and return characteristics of pairs trading with daily data over the period 1962 through December 2002. Using a simple algorithm for choosing pairs, we test the profitability of several straightforward, self-financing trading rules. We find average annualized excess returns of about 11 percent for top-pairs portfolios. While pairs strategies exploit temporary components of stock prices, we show that our profits are not caused by simple mean reversion as documented in the previous literature. We examine the robustness of our results to a wide variety of risk factors – including not only the widely used factors in the empirical literature but also potential low-frequency institutional factors such as bankruptcy risk. In addition, we explore the robustness of our results to microstructure factors such as the bid-ask bounce, short-selling costs, and transactions costs. While some factors such as short-selling and transactions costs affect the magnitude of the excess returns, pairs trading remains profitable for reasonable...
tracking img