Pair Trading

A Pairs Trading Strategy Applied to the European Banking Sector

Simone Bernardi & Alessandro Gnoatto May 19th 2010

Abstract: We test “Pairs trading”, a Wall Street trading strategy that tries to generate profit from market inefficiencies. The idea of pairs trading is quite simple: find two stocks that move together (high correlation of historical data) and take long/short positions when they diverge abnormally (above a given threshold), hoping that the prices will converge in the future (mean reversion of the spread). From an academic point of view, if the weak market efficiency hypothesis is in order, then pairs trading shouldn’t present positive performance. This report aims to investigate if pairs trading does present positive performance, in particular for the European banking sector under different conditions.

This report is part of the lecture “Asset Allocation and Performance Measurement”, by Dr. Nils Tuchschmid, taking place at the university of Zurich during the spring semester 2010. In general, aim of such a report should be the setting up a possible profitable trading strategy and to concretely implement it in order to measure its performance as also the risk it involves. Since we are interested in the study of pairs trading strategies, we choose to refer to the two following papers: (1999) Gatev, E., Goetzman, W. N., Rouwenhorst, K. G. Pairs Trading: Performance of a Relative Value Arbitrage Rule. Working Paper, Yale School of Management. (2007) Perlin, M. S. Evaluation of Pairs Trading Strategy at Brazilian Financial Market. Unpublished Working Paper. We will proceed thanks to the hints found in the paper of Gatev et al. (1999) and follow the methodology accurately described and implemented by Perlin (2007). Contrary to Perlin (2007), who applies the pairs trading strategy to the whole Brazilian market, we choose to restrict our analysis to the European zone, and more precisely, to the banking sector. The motivation for this is that the concentration...