Stock Price Co-Movement and the Foundations of Pairs Trading

55 Pages Posted: 10 Feb 2018

See all articles by Adam Farago

Adam Farago

University of Gothenburg - Centre for Finance

Erik Hjalmarsson

University of Gothenburg - Centre for Finance

Date Written: January 22, 2018

Abstract

We study the theoretical implications of cointegrated stock prices on the profitability of pairs trading strategies. If stock returns are fairly weakly correlated across time, cointegration implies very high Sharpe ratios. To the extent that the theoretical Sharpe ratios are "too large," this suggests that either (i) cointegration does not exist pairwise among stocks, and pairs trading profits are a result of a weaker or less stable dependency structure among stock pairs, or (ii) the serial correlation in stock returns stretches over considerably longer horizons than is usually assumed. Empirically, there is little evidence of cointegration, favoring the first explanation.

Keywords: Pairs trading, Stock price co-movement, Cointegration

JEL Classification: C22, G1

Suggested Citation

Farago, Adam and Hjalmarsson, Erik, Stock Price Co-Movement and the Foundations of Pairs Trading (January 22, 2018). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=3114058

Adam Farago

University of Gothenburg - Centre for Finance ( email )

Box 640
Gothenburg, 405 30
Sweden

Erik Hjalmarsson (Contact Author)

University of Gothenburg - Centre for Finance ( email )

Box 640
Gothenburg, 403 50
Sweden

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