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RFS Advance Access originally published online on February 13, 2006
Review of Financial Studies 2006 19(3):797-827; doi:10.1093/rfs/hhj020
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© The Author 2006. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Pairs Trading: Performance of a Relative-Value Arbitrage Rule

Evan Gatev
Boston College

William N. Goetzmann
Yale University

K. Geert Rouwenhorst
Yale University

Address correspondence to Evan Gatev, Boston College, Carroll School of Management, Fulton Hall, 140 Commonwealth Ave, Chestnut Hill, MA 02467, or email: gatev{at}bc.edu.

We test a Wall Street investment strategy, "pairs trading," with daily data over 1962–2002. Stocks are matched into pairs with minimum distance between normalized historical prices. A simple trading rule yields average annualized excess returns of up to 11% for self-financing portfolios of pairs. The profits typically exceed conservative transaction-cost estimates. Bootstrap results suggest that the "pairs" effect differs from previously documented reversal profits. Robustness of the excess returns indicates that pairs trading profits from temporary mispricing of close substitutes. We link the profitability to the presence of a common factor in the returns, different from conventional risk measures.


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