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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.

Suggested Citation

  • Broussard, John Paul & Vaihekoski, Mika, 2012. "Profitability of pairs trading strategy in an illiquid market with multiple share classes," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(5), pages 1188-1201.
    • Handle: RePEc:eee:intfin:v:22:y:2012:i:5:p:1188-1201
    DOI: 10.1016/j.intfin.2012.06.002
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    References listed on IDEAS

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    1. Nyberg, Peter & Vaihekoski, Mika, 2010. "A new value-weighted total return index for the Finnish stock market," Research in International Business and Finance, Elsevier, vol. 24(3), pages 267-283, September.
    2. Arturo Bris & William N. Goetzmann & Ning Zhu, 2007. "Efficiency and the Bear: Short Sales and Markets Around the World," Journal of Finance, American Finance Association, vol. 62(3), pages 1029-1079, June.
    3. Nyberg, Peter & Vaihekoski, Mika, 2010. "A new value-weighted total return index for the Finnish stock market," Research in International Business and Finance, Elsevier, vol. 24(3), pages 267-283, September.
    4. Mika Vaihekoski, 2009. "Pricing of liquidity risk: empirical evidence from Finland," Applied Financial Economics, Taylor & Francis Journals, vol. 19(19), pages 1547-1557.
    5. 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.
    6. Evan Gatev & William N. Goetzmann & K. Geert Rouwenhorst, 2006. "Pairs Trading: Performance of a Relative-Value Arbitrage Rule," The Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 797-827.
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    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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