Pairs Trading: Performance of a Relative Value Arbitrage Rule
Simon Fraser University
William N. Goetzmann
Yale School of Management - International Center for Finance; National Bureau of Economic Research (NBER)
K. Geert Rouwenhorst
Yale School of Management - International Center for Finance
Yale ICF Working Paper No. 08-03
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.
Number of Pages in PDF File: 47
JEL Classification: G1
Date posted: December 28, 1998 ; Last revised: January 24, 2008
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