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Pairs trading and idiosyncratic cash flow risk

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  • Binh Do
  • Robert Faff

Abstract

We uncover idiosyncratic cash flow risk as a dominant driver for pairs trading performance. The convergence probability and pairs payoff are negatively associated with pairwise idiosyncratic cash flow volatility. Further, pairs portfolio returns load negatively on market‐wide idiosyncratic cash flow volatility. This latter time‐series evidence helps explain a substantial part of the decline in pairs trading profitability in the US equity market since the 1990s. Our results are consistent with idiosyncratic risk representing a major holding cost for arbitrageurs when substitutes are close but imperfect.

Suggested Citation

  • Binh Do & Robert Faff, 2021. "Pairs trading and idiosyncratic cash flow risk," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 61(2), pages 3171-3206, June.
    • Handle: RePEc:bla:acctfi:v:61:y:2021:i:2:p:3171-3206
    DOI: 10.1111/acfi.12697
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    References listed on IDEAS

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