Profitability of pairs trading strategy in an illiquid market with multiple share classes |
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| Authors: | John Paul Broussard Mika Vaihekoski |
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| Institution: | 1. Broussard: School of Business – Camden, Rutgers, The State University of New Jersey, United States;2. Vaihekoski: Turku School of Economics, University of Turku (UTU) and School of Business, Lappeenranta University of Technology (LUT), Finland;1. Department of Metallurgical & Materials Engineering, Indian Institute of Technology Kharagpur, Kharagpur 721302, India;2. Department of Ocean Engineering and Naval Architecture, Indian Institute of Technology Kharagpur, Kharagpur 721302, India;3. University of Pittsburgh, Pittsburgh, PA 15213, United States;4. Department of Management, Durham University Business School, Mill Hill Lane, Durham University, Durham DH1 3LB, United Kingdom;5. Department of Industrial Engineering and Management Indian Institute of Technology, Kharagpur 721302, India;1. Departamento de Economía y Empresa, Universidad de Almería, 04120, Almería, Spain;2. Departamento de Matemáticas, Universidad de Almería, 04120, Almería, Spain;1. Department of Mathematics, City University of Hong Kong, 83 Tat Chee Ave, Kowloon, Hong Kong;2. Department of Mathematics, University of Georgia, Athens, GA 30602, United States |
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| 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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