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Pairs Trading Strategy and Idiosyncratic Risk. Evidence in Spain and Europe.

Last Updated on 10 February, 2024 by Rejaul Karim

Delving into the dynamics of the Pairs Trading strategy, Marisa Mazo, Maria Esther Vaquero Lafuente, and Ricardo Gimeno present a compelling study titled “Pairs Trading Strategy and Idiosyncratic Risk. Evidence in Spain and Europe.”

This research investigates the relationship between pairs trading strategy returns and the movements of a selected pair of stock prices. Crucially, the study introduces a novel model incorporating fundamental variables measuring idiosyncratic factors. By anticipating changes in the long-term relationship between stocks, the model aims to identify and mitigate potential losses resulting from divergence caused by fundamental shifts in one of the companies.

The model’s effectiveness is rigorously tested on European stocks, with results demonstrating superior performance compared to the base distance model. This research introduces valuable insights for refining pairs trading strategies in the context of idiosyncratic risk in Spain and Europe.

Abstract Of Paper

Pairs trading strategy’s return depends on the divergence/convergence movements of a selected pair of stocks’ prices. However, if the stable long term relationship of the stocks changes, price will not converge and the trade opened after divergence will close with losses. We propose a new model that, including companies’ fundamental variables that measure idiosyncratic factors, anticipates the changes in this relationship and rejects those trades triggered by a divergence produced by fundamental changes in one of the companies. The model is tested on European stocks and the results obtained outperform those of the base distance model.

Original paper – Download PDF

Here you can download the PDF and original paper of Pairs Trading Strategy and Idiosyncratic Risk. Evidence in Spain and Europe.

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Author

Marisa Mazo
Comillas Pontifical University

Maria Esther Vaquero Lafuente
Comillas Pontifical University – Department of Financial Management

Ricardo Gimeno
Banco de España

Conclusion

In conclusion, our exploration of the Pairs Trading strategy unveils a crucial factor influencing its returns—idiosyncratic risk. The conventional strategy hinges on the divergence/convergence dynamics of paired stock prices, yet its vulnerability to long-term shifts in stock relationships poses a challenge.

To address this, we introduce an innovative model incorporating fundamental variables measuring idiosyncratic factors. By anticipating shifts in the stable long-term relationship between paired stocks, our model acts as a preemptive safeguard against trades triggered by fundamental changes.

Rigorously tested on European stocks, our model surpasses the base distance model, signifying a robust enhancement in anticipating and navigating the intricacies of idiosyncratic risk within the Pairs Trading strategy. This marks a noteworthy stride in refining the strategy’s resilience and adaptability in dynamic market conditions.

Related Reading:

On the Determinants of Pairs Trading Profitability

European Equity Pairs Trading: The Effect of Data Frequency on Risk and Return

FAQ

– What is the main focus of the study “Pairs Trading Strategy and Idiosyncratic Risk. Evidence in Spain and Europe” by Marisa Mazo, Maria Esther Vaquero Lafuente, and Ricardo Gimeno?

The main focus of the study is to investigate the relationship between pairs trading strategy returns and the movements of a selected pair of stock prices. The research introduces a novel model that incorporates fundamental variables measuring idiosyncratic factors. This model aims to anticipate changes in the long-term relationship between stocks and mitigate potential losses resulting from divergence caused by fundamental shifts in one of the companies.

– How does the proposed model in the study address the challenge posed by long-term shifts in stock relationships within the Pairs Trading strategy?

The proposed model introduces fundamental variables measuring idiosyncratic factors to anticipate changes in the stable long-term relationship between paired stocks. By doing so, the model acts as a preemptive safeguard against trades triggered by fundamental changes in one of the companies. This addresses the vulnerability of the conventional Pairs Trading strategy to long-term shifts in stock relationships, aiming to enhance its resilience and adaptability.

– What are the key findings of the study regarding the effectiveness of the proposed model when tested on European stocks, and how does it compare to the base distance model?

When rigorously tested on European stocks, the proposed model demonstrates superior performance compared to the base distance model. The results indicate that the model, incorporating fundamental variables to measure idiosyncratic factors, outperforms the conventional approach. This suggests that the innovative model is more effective in anticipating and navigating the intricacies of idiosyncratic risk within the Pairs Trading strategy, marking a significant stride in refining its resilience and adaptability in dynamic market conditions.

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