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Pairs Trading: Performance of a Relative Value Arbitrage Rule

  • William Goetzmann

    ()

    (Yale School of Management)

  • Evan g. Gatev

    ()

    (Boston College - Department of Finance)

  • K. Geert Rouwenhorst

    ()

    (Yale School of Management)

We test a Wall Street investment strategy known as "pairs trading" with daily data over the period 1962 through 1997. Stocks are matched into pairs according to minimum distance in historical normalized price space. We test the profitability of several trading rules with six-month trading periods over the 1962-1997 period, and find average annualized excess returns of up to 12 percent for a number of self-financing portfolios of top pairs. Part of these profits may be due to market microstructure effects. Nevertheless, our historical trading profits exceed a conservative estimate of transaction costs through most of the period. We bootstrap random pairs in order to distinguish pairs trading from pure mean-reversion strategies. The bootstrap results suggest that the ?pairs? effect differs from previously documented mean reversion profits.

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Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm3.

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Date of creation: 01 Nov 1998
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Handle: RePEc:ysm:somwrk:ysm3
Contact details of provider: Web page: http://icf.som.yale.edu/

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  1. Bossaerts, Peter, 1988. "Common nonstationary components of asset prices," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 347-364.
  2. Chen, Zhiwu & Knez, Peter J, 1995. "Measurement of Market Integration and Arbitrage," Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 287-325.
  3. Petersen, Mitchell A. & Fialkowski, David, 1994. "Posted versus effective spreads *1: Good prices or bad quotes?," Journal of Financial Economics, Elsevier, vol. 35(3), pages 269-292, June.
  4. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
  5. Jegadeesh, Narasimhan & Titman, Sheridan, 1993. " Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," Journal of Finance, American Finance Association, vol. 48(1), pages 65-91, March.
  6. KENT D. DANIEL & David Hirshleifer & AVANIDHAR SUBRAHMANYAM, 2004. "A Theory of Overconfidence, Self-Attribution, and Security Market Under- and Over-reactions," Finance 0412006, EconWPA.
  7. Brock, W. & Lakonishok, J. & Lebaron, B., 1991. "Simple Technical Trading Rules And The Stochastic Properties Of Stock Returns," Working papers 90-22, Wisconsin Madison - Social Systems.
  8. Mark J Ready, 2002. "Profits from Technical Trading Rules," Financial Management, Financial Management Association, vol. 31(3), Fall.
  9. Charles M. C. Lee & James Myers & Bhaskaran Swaminathan, 1999. "What is the Intrinsic Value of the Dow?," Journal of Finance, American Finance Association, vol. 54(5), pages 1693-1741, October.
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