An Anatomy of Pairs Trading: the role of idiosyncratic news, common information and liquidity

In this paper, we examine the pro…tability from a convergence trading strategy called pairs trading which bets that a pair of stocks with price paths that have historically moved together will eventually converge if they ever diverge. We …nd that the pro…tability from pairs trading is greatest soon after the pairs diverge and that the pro…tability is strongly related to events around the date of divergence. Pro…tability is low when there is idiosyncratic news about a stock in the pair and high when there is an idiosyncratic liquidity shock to a stock in the pair. When there is information common to both stocks in the pair, we …nd that the pro…ts to pairs trading can be high when frictions cause this information to be more quickly incorporated into one stock in the pair and not the other. We further show how idiosyncratic news, common information and liquidity are systematically related to horizon risk, divergence risk and the speed of convergence of the pairs trading, which illustrates some subtle trade-o¤s faced by arbitragers when attempting to arbitrage such potential mispricing. (JEL Classi…cation: G11, G12, G14) We are grateful to Robert Battalio, Shane Corwin, Tom Cosimano, Zhi Da, Levent Guntay, Tim Loughran, Todd Pulvino, Paul Schultz, Sophie Shive, and several empolyees at Lehman Brothers for helpful discussions and comments. We also thank seminar participants at the University of Notre Dame and the Indiana-Purdue-Notre Dame Joint Conference on Finance for valuable feedback. The Zell Center for Risk Management and the Financial Market and Institution Center provided partial funding for this research. All errors are our own. yCorrespondence: Joseph Engelberg, Finance Area, Kenan Flagler Business School, University of North Carolina at Chapel Hill; Pengjie Gao, Finance Department, Mendoza College of Business, University of Notre Dame; and Ravi Jagannathan, Finance Department, Kellogg School of Management, Northwestern University and NBER. E-mail: joseph_engelberg@kenan-‡agler.unc.edu, [email protected], and [email protected].