Pairs trading and idiosyncratic cash flow risk

We uncover idiosyncratic cash flow risk as a dominant driver for pairs trading performance. The convergence probability and pairs payoff are negatively associated with pairwise idiosyncratic cash flow volatility. Further, pairs portfolio returns load negatively on market-wide idiosyncratic cash flow volatility. This latter time-series evidence helps explain a substantial part of the decline in pairs trading profitability in the US equity market since the 1990s. Our results are consistent with idiosyncratic risk representing a major holding cost for arbitrageurs when substitutes are close but imperfect.