Pairs Trading: Performance of a Relative-Value Arbitrage Rule

We test a Wall Street investment strategy, "pairs trading,"with daily data over 1962–2002. Stocks are matched intopairs with minimum distance between normalized historical prices.A simple trading rule yields average annualized excess returnsof up to 11% for self-financing portfolios of pairs. The profitstypically exceed conservative transaction-cost estimates. Bootstrapresults suggest that the "pairs" effect differs from previouslydocumented reversal profits. Robustness of the excess returnsindicates that pairs trading profits from temporary mispricingof close substitutes. We link the profitability to the presenceof a common factor in the returns, different from conventionalrisk measures.