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Pairs trading and idiosyncratic cash flow risk
Author(s) -
Do Binh,
Faff Robert
Publication year - 2021
Publication title -
accounting and finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.645
H-Index - 49
eISSN - 1467-629X
pISSN - 0810-5391
DOI - 10.1111/acfi.12697
Subject(s) - cash flow , systematic risk , financial economics , economics , volatility (finance) , arbitrage , limits to arbitrage , portfolio , equity (law) , monetary economics , business , econometrics , finance , political science , law
We uncover idiosyncratic cash flow risk as a dominant driver for pairs trading performance. The convergence probability and pairs payoff are negatively associated with pairwise idiosyncratic cash flow volatility. Further, pairs portfolio returns load negatively on market‐wide idiosyncratic cash flow volatility. This latter time‐series evidence helps explain a substantial part of the decline in pairs trading profitability in the US equity market since the 1990s. Our results are consistent with idiosyncratic risk representing a major holding cost for arbitrageurs when substitutes are close but imperfect.