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Pairs trading across Mainland China and Hong Kong stock markets

Pairs trading across Mainland China and Hong Kong stock markets
Pairs trading across Mainland China and Hong Kong stock markets

Motivated by the rationale that market inefficiency arises from a combination of less than fully rational demand and limits to arbitrage, this paper investigates the profitability of pairs trading across Mainland China and Hong Kong on highly liquid large-cap and midcap stocks from January 1996 to July 2017. We have three main findings. First, we find that pairs trading constrained within each market generates no significant abnormal returns. However, if investors can trade across Mainland China and Hong Kong, pairs trading is profitable after adjusting for risk and transaction costs, where the annualized abnormal return is 9% over the full sample. Second, by using a rolling-window regression, we find that the profitability of the strategy is time-varying. The bootstrap simulations suggest that the decline in profitability of the strategy since 2012 is due to random chance rather than poor ability of identifying mispriced stocks. However, the vast majority of profitable periods reflect the strategy's ability to choose profitable stocks rather than random chance. Third, the profitability of the strategy is somewhat sensitive to market conditions, most notably, the strategy is more profitable during longer term market turbulence. Overall, our empirical findings are consistent with the Adaptive Market Hypothesis in that the integration of financial markets and market conditions determine the level of market efficiency.

Adaptive Market Hypothesis, bootstrap simulation, cross-border trading, market conditions, market efficiency, pairs trading
1076-9307
1-29
Zhang, Hanxiong
40dbaa6e-dc42-4df9-9703-0b219e36eec7
Urquhart, Andrew
ee369df1-95b5-4cdf-bc24-f1be77357c03
Zhang, Hanxiong
40dbaa6e-dc42-4df9-9703-0b219e36eec7
Urquhart, Andrew
ee369df1-95b5-4cdf-bc24-f1be77357c03

Zhang, Hanxiong and Urquhart, Andrew (2018) Pairs trading across Mainland China and Hong Kong stock markets. International Journal of Finance and Economics, 1-29. (doi:10.1002/ijfe.1687).

Record type: Article

Abstract

Motivated by the rationale that market inefficiency arises from a combination of less than fully rational demand and limits to arbitrage, this paper investigates the profitability of pairs trading across Mainland China and Hong Kong on highly liquid large-cap and midcap stocks from January 1996 to July 2017. We have three main findings. First, we find that pairs trading constrained within each market generates no significant abnormal returns. However, if investors can trade across Mainland China and Hong Kong, pairs trading is profitable after adjusting for risk and transaction costs, where the annualized abnormal return is 9% over the full sample. Second, by using a rolling-window regression, we find that the profitability of the strategy is time-varying. The bootstrap simulations suggest that the decline in profitability of the strategy since 2012 is due to random chance rather than poor ability of identifying mispriced stocks. However, the vast majority of profitable periods reflect the strategy's ability to choose profitable stocks rather than random chance. Third, the profitability of the strategy is somewhat sensitive to market conditions, most notably, the strategy is more profitable during longer term market turbulence. Overall, our empirical findings are consistent with the Adaptive Market Hypothesis in that the integration of financial markets and market conditions determine the level of market efficiency.

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Accepted/In Press date: 10 September 2018
e-pub ahead of print date: 19 October 2018
Keywords: Adaptive Market Hypothesis, bootstrap simulation, cross-border trading, market conditions, market efficiency, pairs trading

Identifiers

Local EPrints ID: 426154
URI: http://eprints.soton.ac.uk/id/eprint/426154
ISSN: 1076-9307
PURE UUID: cddd917a-3256-4744-b3f9-d4b24db8e903
ORCID for Andrew Urquhart: ORCID iD orcid.org/0000-0001-8834-4243

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Date deposited: 15 Nov 2018 17:30
Last modified: 28 Apr 2022 04:02

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Contributors

Author: Hanxiong Zhang
Author: Andrew Urquhart ORCID iD

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