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RFS Advance Access published online on February 13, 2006
Review of Financial Studies, 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

Article

Pairs Trading: Performance of a Relative Value Arbitrage Rule

Evan Gatev 1 *, William N. Goetzmann 2, and K. Geert Rouwenhorst 3
1 Assistant Professor, Boston College
2 Edwin J. Beinecke Professor of Finance and Management Studies, Yale University
3 Professor, Yale University

* To whom correspondence should be addressed.
Evan Gatev, E-mail: gatev{at}bc.edu


  Abstract

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 percent for self-financing portfolios of pairs. The profits typically exceed conservative transaction costs 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 mis-pricing 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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