Pairs‐trading and spread persistence in the European stock market

Abstract

In this paper, we adapt the demand and supply framework introduced by Figuerola-Ferretti and Gonzalo (Journal of Econometrics, 2010) to illustrate the dynamics of pairs-trading. We underline the process by which a finite elasticity of demand for spread trading determines the speed of mean reversion and pairstrading profitability. A persistence-dependent trading trigger is introduced accordingly. Applied to STOXX Europe 600-traded equities, our strategy exploits price leadership for portfolio replication purposes and delivers Sharpe ratios that outperform the benchmark rules used in the literature. Portfolio performance and mean reversion are enhanced after firm fundamental factor restrictions are imposed. K E Y W O R D S cointegration, error persistence, pairs-trading, price discovery, trading trigger J E L C L A S S I F I C A T I O N C58, G11, G12, G14 | INTRODUCTIONShort-term price discrepancies are common across assets that are imperfectly integrated. Pairs-trading strategies are designed to earn profits from relative mispricings of closely related assets. This paper exploits commonalities arising from cointegrated assets to model relative value arbitrage via pairs-trading strategies. Pairs-trading belongs to the family of convergence trade strategies. It relies on a well-known trading rule for cointegrated price series based on simultaneous long-short positions that are closed when prices revert to a long-run relationship. When an investor opens a position he shorts the outperformer and longs the underperformer, until the mispricing is eliminated. We extend the Figuerola-Ferretti and Gonzalo (2010) (FFG hereafter) demand and supply framework to describe price dynamics in two distinct but cointegrated assets and show how market participants exploit temporary mispricings performing pairs-trading strategies. The setup requires a finite elasticity of arbitrage services and cointegration error persistence. It evolves around the speed by which arbitrageurs restore equilibrium allowing the measurement of price discovery for portfolio replication purposes and arbitrage profit determination. A market is regarded as dominant in this framework if it concentrates a larger number of participants. Cointegration, therefore, guarantees price convergence that is represented in terms of a stationary error correction term. A trading trigger is derived, which is linked to the degree of persistence of the cointegration error so that a higher stationarity requires a lower trading trigger. This paper is related to Gatev, Goetzmann, and Rouwenhorst (2006) (GGR hereafter), who examine the performance of pairs-trading using the daily U.S. stock return data. GGR performs pairs selection using the minimum-distance algorithm.J Futures Markets. 2018;38:998-1023. wileyonlinelibrary.com/journal/fut 998 | They find economically and statistically significant excess returns of around 11% per annum. Following GGR, Andrade, di Pietro, and Seasholes (2005); Broussard and Vaihekoski (2012); and Bowen and Hutchinson (2016) apply the algorithm to As...

Mispricings in Global Energy Markets

“…Moreover, while the reported kurtosis in pairs trading portfolios is of comparable size to those reported by benchmark indexes, pairs trading profitability exhibits a positively skewed distribution while the three market indexes considered show a negative skew in the return distribution. The finding of positively skewed returns in the three pairs trading portfolios is consistent with the literature (see (Figuerola-Ferretti, Paraskevopoulos, and Tang 2018), (Gatev, Goetzmann, and Rouwenhorst 2006) and (Jurek and Yang 2007)).…”

“…In this paper we use the framework introduced by (Figuerola-Ferretti, Paraskevopoulos, and Tang 2018) to identify how deviations from underlying fundamentals can be used to earn pairs trading profitability with a persistence linked trading trigger. We analyze for this purpose a sample of daily prices of European, US and Asian energy corporations covering the 2002-2021 period.…”

Some Notes on the Formation of a Pair in Pairs Trading

“…In 2004, Vidyamurthy [17] presented the theoretical framework for pair selection using the cointegration method. Since then, different analysis have been carried out using this methodology in different markets, such us the European market [18,19], the DJIA stocks [20], the Brazilian market [21,22] or the STOXX 50 index [23]. Galenko et al [24] made an application of the cointegration method to arbitrage in fund traded on different markets.…”