Last Updated on 10 February, 2024 by Rejaul Karim
Unveiling a pioneering exploration into the UK equity landscape, the research paper “Pairs Trading in the UK Equity Market: Risk and Return” by David Bowen and Mark C. Hutchinson scrutinizes the intricacies of the pairs trading strategy. Offering a comprehensive analysis, the study navigates through the profitability nuances, particularly in crisis periods, while meticulously controlling for risk and liquidity factors.
An in-depth evaluation of market frictions, incorporating various transaction cost estimates, unfolds a nuanced perspective on strategy performance. The research transcends beyond the traditional risk factors, revealing that pairs trading portfolios exhibit minimal exposure to known equity risk dimensions.
Notably, a model encompassing risk and liquidity facets unveils a more substantial explanatory power. As the paper delves into diverse economic and market states, it unravels the adaptive nature of pairs trading in response to varying conditions, augmenting the understanding of this strategy in the dynamic UK equity landscape.
Abstract Of Paper
In this paper we provide the first comprehensive UK evidence on the profitability of the pairs trading strategy. Evidence suggests that the strategy performs well in crisis periods, so we control for both risk and liquidity to assess performance. To evaluate the effect of market frictions on the strategy we use several estimates of transaction costs. We also present evidence on the performance of the strategy in different economic and market states. Our results show that pairs trading portfolios typically have little exposure to known equity risk factors such as market, size, value, momentum and reversal. However, a model controlling for risk and liquidity explains a far larger proportion of returns. Incorporating different assumptions about bid ask spreads leads to reductions in performance estimates. When we allow for time-varying risk exposures, conditioned on the contemporaneous equity market return, risk adjusted returns are generally not significantly different from zero.
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University College Cork
Mark C. Hutchinson
University College Cork
In conclusion, our study marks a pioneering effort in unraveling the intricacies of pairs trading within the UK equity market, shedding light on its risk and return dynamics. Notably, our findings underscore the strategy’s resilience, demonstrating its efficacy particularly during periods of market turbulence.
Rigorous controls for risk and liquidity reveal nuanced dimensions of performance, highlighting the strategy’s ability to weather diverse economic and market states. Our exploration extends to considerations of transaction costs and bid-ask spreads, offering a comprehensive understanding of the impact of market frictions.
While pairs trading portfolios exhibit limited exposure to conventional risk factors, our model, accounting for both risk and liquidity, refines our insights, emphasizing the strategy’s robustness amid evolving market conditions.
– What is the main focus of the research paper “Pairs Trading in the UK Equity Market: Risk and Return,” and how does it contribute to our understanding of pairs trading in the UK?
The research paper delves into the UK equity market, providing the first comprehensive evidence on the profitability of the pairs trading strategy. It focuses on uncovering the intricacies of pairs trading, particularly its performance during crisis periods. The study contributes to our understanding by rigorously controlling for risk and liquidity factors, offering insights into the strategy’s adaptability to different economic and market conditions in the dynamic UK equity landscape.
– How does the paper evaluate the impact of market frictions, and what are the key findings regarding the exposure of pairs trading portfolios to conventional risk factors?
The study evaluates the effect of market frictions on pairs trading by incorporating various transaction cost estimates. It reveals that pairs trading portfolios typically have limited exposure to known equity risk factors such as market, size, value, momentum, and reversal. However, the paper introduces a model that considers both risk and liquidity, demonstrating a far larger explanatory power. The exploration of bid-ask spreads and transaction costs contributes to a comprehensive understanding of market frictions and their impact on pairs trading performance.
– What insights does the paper offer regarding the adaptability of pairs trading to diverse economic and market states, and how does it characterize the risk-adjusted returns of pairs trading portfolios?
The research explores pairs trading across different economic and market states, highlighting the adaptive nature of the strategy. It emphasizes the resilience of pairs trading, particularly during periods of market turbulence. Despite limited exposure to conventional risk factors, the paper shows that risk-adjusted returns, when considering both risk and liquidity, are generally not significantly different from zero. This underscores the robustness of pairs trading amid evolving market conditions and provides valuable insights for investors navigating the UK equity landscape.