Pairs Trading with Costly Short-Selling

63 Pages Posted: 16 Jun 2023 Last revised: 26 Feb 2024

See all articles by Jing Xu

Jing Xu

Renmin University of China - School of Finance

Peiquan Yang

Renmin University of China - School of Finance

Date Written: February 26, 2024

Abstract

We study an optimal pairs trading model with costly short-selling. When the investor has logarithm utility function, we derive the solution in closed form, which shows that: the optimal allocation functions are piece-wise linear in the pair's relative price; stock borrowing fees asymmetrically reduce the optimal size of the long/short position; and for risk-hedging purpose, it can be optimal to short sell even when the stock borrowing fees outweigh the expected return earned from short selling. When the investor has power utility function, we propose analytical allocation functions adopting which only causes a small utility loss. When the investor is constrained from borrowing funds, the margin requirement for short selling can significantly affect the trading strategy. Empirically, we demonstrate the importance of incorporating short selling costs when trading pairs in China's stock market and verify the model-implied relation between short selling costs and profitability of pairs trading.

Keywords: portfolio choice, pairs trading, risky arbitrage, short selling cost

JEL Classification: C32, G11, G12

Suggested Citation

Xu, Jing and Yang, Peiquan, Pairs Trading with Costly Short-Selling (February 26, 2024). Available at SSRN: https://ssrn.com/abstract=4470496 or http://dx.doi.org/10.2139/ssrn.4470496

Jing Xu (Contact Author)

Renmin University of China - School of Finance ( email )

59 Zhongguancun Street
Beijing, 100872
China

Peiquan Yang

Renmin University of China - School of Finance ( email )

Ming De Main Building
Renmin University of China
Beijing, Beijing 100872
China

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