Risk-adjusted Returns from Statistical Arbitrage Opportunities in Indian Stock Futures Market

Abstract

Statistical arbitrage is a trading strategy that employs time series methods to identify relative mispricing between securities based on the expected values of these assets. The Pairs Trading, one of the techniques of statistical arbitrage, is a market neutral trading strategy. The main objective of this paper is to investigate the profitability and risks of pairs trading strategy for various stocks. The daily future prices of stocks traded and listed on NSE over 2011–2017 are used on rolling basis to compute the performance based on the selection of pairs through minimizing the sum of squared deviation (distance method) and the selection based on cointegration tests (cointegration method) for identifying stocks suited for pairs trading strategies. The pairs trading strategy is performed in two stages: the formation period and the trading period. The strategy is created by long position in one stock and short position in other stock of the pair identified. To examine the risk of pairs trading and the drivers of returns, the portfolio returns are risk-adjusted using Fama and French (J Financ Econ 33:3–56, 1993) three factor asset pricing model. The study reveals that pairs trading in related stocks is significantly profitable with average annualized profitability of up to 34% including transaction costs. The evidence of pairs trading profits in stock futures supports the view that these profits reflect compensation to arbitrageurs for enforcing the law of one price in similarly related markets to ensure market efficiency. Indian financial markets are maturing and are attracting sizable retail and institutional investments. Advanced applications like the one presented in this study are of significance for the investors and investment consultants so that they can benefit from such trading strategies.