Pairs Trading and Stock Returns: An Evidence from Pakistan Stock Exchange
Market Efficiency Hypothesis includes the strong, semi-strong and weak form of efficiencies that exists in the market. Weak form of efficiency states that future price of the stocks cannot be determined by using past prices in any way. But there exists Arbitrage Pricing Theory which states that profits can be attained by selling over-valued stocks and buying the under-valued stocks. Pairs Trading concept was generated in 1980 by Nanzio Tartaglia. Qazi, Rahman, & Gul, 2015 defined pairs trading as statistical arbitrage approach that short term changes concurrently reflected by two stocks for long-run equilibrium position benefits trader. This research focused on the stock returns of financial and non-financial sector of Pakistan Stock Exchange for a period of seven years from 2009 to 2016 through pairs trading concept and also includes Jensen Alpha model for risk-adjusted returns. Under the distance approach proposed by (Gatev et al., 2006; Bolgun et al., 2010; Kanamura, 2008; Pizzutelo, 2013; Perlin, 2008), pairs are formed using minimum squared distance between pairs and then traded. Evidence has been found regarding the high stock returns ranging upto 18.48% and 27.93% per annum using pairs trading and hypothesis are accepted.
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