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http://ssrn.com/abstract=1330689
 
 

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An Anatomy of Pairs Trading: The Role of Idiosyncratic News, Common Information and Liquidity


Joseph Engelberg


University of California, San Diego (UCSD) - Rady School of Management

Pengjie Gao


University of Notre Dame - Mendoza College of Business

Ravi Jagannathan


Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); SAIF; ISB

November 17, 2008

Third Singapore International Conference on Finance 2009

Abstract:     
"Pairs trading" involves taking a bet that the price paths of two stocks that have historically moved together will converge again after any divergence. Consistent with the view that profits to pairs trading comes through market making, i.e., short term liquidity provision and price discovery; we find that pairs trading profits are higher when the initial divergence is due to (a) news that temporarily reduces the liquidity of one of the stocks in the pair, or (b) news that affects both stocks in the pair, and there are a priori reasons to believe that one stock reacts faster to such news. Profits are lower when the initial divergence in prices is associated with value relevant news specific to a stock in the pair. Pairs involving smaller, less liquid and more volatile stocks tend to converge faster after initial divergence. When one of the stocks in the pair is more likely to have sluggish response to common information as evidenced by less common sell side coverage and institutional holdings, the risk of a margin call due to further divergence is lower. Closing out positions that do not converge within 10 days leads to higher risk adjusted returns ignoring transactions costs when compared to holding positions for 6 months.

Number of Pages in PDF File: 68

Keywords: Pairs Trading, News, Liquidity Shocks, Convergence Trade

JEL Classification: G11, G12, G14

working papers series


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Date posted: January 22, 2009 ; Last revised: March 20, 2009

Suggested Citation

Engelberg, Joseph and Gao, Pengjie and Jagannathan, Ravi, An Anatomy of Pairs Trading: The Role of Idiosyncratic News, Common Information and Liquidity (November 17, 2008). Third Singapore International Conference on Finance 2009. Available at SSRN: http://ssrn.com/abstract=1330689 or http://dx.doi.org/10.2139/ssrn.1330689

Contact Information

Joseph Engelberg
University of California, San Diego (UCSD) - Rady School of Management ( email )
9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
Pengjie Gao
University of Notre Dame - Mendoza College of Business ( email )
246 Mendoza College of Business
Notre Dame, IN 46556-5646
United States
(574) 631-8048 (Phone)
Ravi Jagannathan (Contact Author)
Northwestern University - Kellogg School of Management ( email )
2001 Sheridan Road
429 Andersen Hall
Evanston, IL 60208
United States
847-491-8338 (Phone)
847-491-5719 (Fax)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
SAIF ( email )
Shanghai
China
ISB ( email )
Hyderabad, Gachibowli 500 019
India
Feedback to SSRN


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