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
Pages (from-to)	3171-3206
Number of pages	36
Journal	Accounting and Finance
Volume	61
Issue number	2
Early online date	27 Sept 2020
DOIs	https://doi.org/10.1111/acfi.12697
Publication status	Published - Jun 2021
Externally published	Yes

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10.1111/acfi.12697

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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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AB - 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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Pairs trading and idiosyncratic cash flow risk

Abstract

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