Pairs trading and spread persistence in the European Stock Market

This paper presents an equilibrium framework based on equity commonality explicitly
adapted to describe the dynamics of pairs trading. Our methodology, built
on the price discovery model of Figuerola-Ferretti and Gonzalo (Journal of Econometrics
2010) exploits price leadership for portfolio replication purposes and shows
how pairs trading pro tability is linked to the speed of equilibrium reversion. A
persistence-dependent trading trigger is introduced to impose higher thresholds on
pairs with slower mean reversion. Our model demonstrates that equilibrium price
convergence guarantees market neutrality and positive abnormal pro tability. Applied
to STOXX Europe 600 traded equities our strategy delivers Sharpe ratios
that outperform benchmark rules used in the literature. Portfolio performance is
enhanced after rm fundamental factor restricitons are impossed.