Pairs Trading Strategy

Evaluation of Pairs Trading Strategy in the Japanese Market

Yuxuan Xiong

Australian National University

Author Note

Supervisor: David Tan Group: Bears and Pairs Date: 2011.08.05

Abstract

Pairs trading strategy was first invented in late 80s and 50 million dollars profit was reported. The key points of making profit are identification of good pairs and efficient trading algorithm. The herding behavior of Japanese firms and the unique corporate organization, Keiretsu, in Japan lead to a result that stocks from different industry tend to be highly correlated. Therefore, more potential pairs are provided and high profit is expected. This research will focus on the relationship between profit of pairs trading and Keiretsu and will show whether the profit for Keiretsu firms will dominant and whether the profit will be more stable through out time under different market conditions. Besides, the existence of higher excess return under bear market will also be examined.

Keywords: Keiretsu, pairs trading

Contents

Introduction 4

Research Design 6

Construct the Pairs Trading Algorithm 7

Compare the performances of two groups 9

Transaction Cost 10

commission fee 10

cost of market impact 11

Data 11

Evaluation of Pairs Trading Strategy in the Japanese Market

Introduction

Pairs trading strategy is a market neutral strategy, which attempts to statistically pick up two stocks as a pair that move together in the past and take long and short positions to make profit. This strategy is a statistical arbitrage strategy to take advantage of market inefficiency. The implementation of this strategy is: arbitrageurs find two stocks whose price move together over an indicated historical observation period and short the increasing-price stock while simultaneously long the decreasing-price stock when the price of these two stocks diverge, hoping they will converge in the future and close positions by then. This strategy was first developed by...