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Profitability of pairs trading strategy in an illiquid market with multiple share classes

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  • Broussard, John Paul
  • Vaihekoski, Mika

Abstract

We investigate the practical issues of implementing the self-financing pairs portfolio trading strategy presented by Gatev et al. (2006). We also provide new evidence on the profitability of pairs trading under different weighting structures and trade initiation conditions. Using data from the Finnish stock market over the period 1987–2008, we find pairs trading to be profitable even after allowing for a one day delay in the trade initiation after the signal. On average, the annualized return can be as high as 12.5%, though requiring trading on days a pair is traded lowers the return approximately by three percentage points. On the other hand, lowering the threshold for opening a pair is found to increase returns even after accounting for trading costs, indicating that there might be a more optimal trade initiation threshold available than that presented in earlier literature. The profits are not related to market risk. Pairs trading strategy is found to produce positive alpha during the sample period.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Financial Markets, Institutions and Money.

Volume (Year): 22 (2012)
Issue (Month): 5 ()
Pages: 1188-1201

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Handle: RePEc:eee:intfin:v:22:y:2012:i:5:p:1188-1201

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Web page: http://www.elsevier.com/locate/intfin

Related research

Keywords: Pairs-trading; Statistical-arbitrage; Long-Short; OMXH; Finland;

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References

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  1. Evan Gatev & William N. Goetzmann & K. Geert Rouwenhorst, 1998. "Pairs Trading: Performance of a Relative Value Arbitrage Rule," Yale School of Management Working Papers ysm26, Yale School of Management.
  2. Hakkio, Craig S. & Rush, Mark, 1991. "Cointegration: how short is the long run?," Journal of International Money and Finance, Elsevier, vol. 10(4), pages 571-581, December.
  3. Arturo Bris & William N. Goetzmann & Ning Zhu, 2004. "Efficiency and the Bear: Short Sales and Markets around the World," Yale School of Management Working Papers ysm15, Yale School of Management.
  4. Mika Vaihekoski, 2009. "Pricing of liquidity risk: empirical evidence from Finland," Applied Financial Economics, Taylor & Francis Journals, vol. 19(19), pages 1547-1557.
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Cited by:
  1. Nyberg, Peter & Vaihekoski, Mika, 2014. "Descriptive analysis of the Finnish stock market: Part II," Research Discussion Papers 10/2014, Bank of Finland.
  2. Fabio Pizzutilo, 2013. "A Note on the Effectiveness of Pairs Trading For Individual Investors," International Journal of Economics and Financial Issues, Econjournals, vol. 3(3), pages 763-771.

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