Pairs Trading and Spread Persistence in the European Stock Market
Forthcoming, Journal of Futures Markets
Posted: 11 Nov 2017 Last revised: 6 May 2018
Date Written: April 30, 2018
Abstract
In this paper we adapt the demand and supply framework introduced by Figuerola-Ferretti and Gonzalo (Journal of Econometrics 2010) to illustrate the dynamics of pairs trading. We underline the process by which a finite elasticity of demand for spread trading determines the speed of mean reversion and pairs trading profitability. A persistence-dependent trading trigger is introduced accordingly. Applied to STOXX Europe 600 traded equities our strategy exploits price leadership for portfolio replication purposes and delivers Sharpe ratios that outperform the benchmark rules used in the literature. Portfolio performance and mean reversion are enhanced after firm fundamental factor restrictions are imposed.
Keywords: pairs trading, cointegration, price discovery, error persistence, trading trigger
JEL Classification: C58, G11, G12, G14
Suggested Citation: Suggested Citation