Pairs trading and spread persistence in the European Stock Market

Abstract

This paper presents an equilibrium framework based on equity commonality explicitly adapted to describe the dynamics of pairs trading. Our methodology, built on the price discovery model of Figuerola-Ferretti and Gonzalo (Journal of Econometrics 2010) exploits price leadership for portfolio replication purposes and shows how pairs trading pro tability is linked to the speed of equilibrium reversion. A persistence-dependent trading trigger is introduced to impose higher thresholds on pairs with slower mean reversion. Our model demonstrates that equilibrium price convergence guarantees market neutrality and positive abnormal pro tability. Applied to STOXX Europe 600 traded equities our strategy delivers Sharpe ratios that outperform benchmark rules used in the literature. Portfolio performance is enhanced after rm fundamental factor restricitons are impossed.