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Stock Price Co-Movement and the Foundations of Pairs Trading

Published online by Cambridge University Press:  24 August 2018

Adam Farago  and
Erik Hjalmarsson
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Abstract

We study the theoretical implications of cointegrated stock prices on the profitability of pairs-trading strategies. If stock returns are fairly weakly correlated across time, cointegration implies very high Sharpe ratios. To the extent that the theoretical Sharpe ratios are “too large,” our results suggest that either i) cointegration does not exist pairwise among stocks, and pairs-trading profits are a result of a weaker or less stable dependency structure among stock pairs, or ii) the serial correlation in stock returns stretches over considerably longer horizons than is usually assumed. Empirically, there is little evidence of cointegration, favoring the first explanation.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 54 , Issue 2 , April 2019 , pp. 629 - 665
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

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Footnotes

1

We have benefited from comments by an anonymous referee, Hendrik Bessembinder (the editor), Kim Christensen, David Edgerton, Randi Hjalmarsson, Pär Österholm, Richard Payne, Joakim Westerlund, and seminar participants at CREATES, Lund University, Örebro University, the 2016 Southampton Finance and Econometrics Workshop, and the 2017 European Summer Meeting of the Econometric Society. The authors gratefully acknowledge financial support from the Nasdaq Nordic Foundation.

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