Pairs trading and idiosyncratic cash flow risk

Binh Do; Robert Faff

doi:10.1111/acfi.12697

Pairs trading and idiosyncratic cash flow risk

Binh Do^*, Robert Faff

^*Corresponding author for this work

Research output: Contribution to journal › Article › Research › peer-review

Abstract

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.

Original language	English
Journal	Accounting and Finance
DOIs	https://doi.org/10.1111/acfi.12697
Publication status	E-pub ahead of print - 27 Sep 2020
Externally published	Yes

Access to Document

10.1111/acfi.12697

Link to publication in Scopus

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abstract = "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.",

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