Middle Eastern Finance and Economics, pp.38-54, 2010 (Peer-Reviewed Journal)
Recent evidence from US stock markets shows that pairs trading strategy earns
positive abnormal profits. The profitable implementation of this strategy requires the
existence of strong arbitrage forces to make the prices of the stocks in a pair converge soon
after the position is opened. This paper argues that arbitrage forces and as a result the
performance of pairs trading strategy will be weaker in emerging than developed markets.
To present evidence on this claim, it examines the performance of pairs trading strategy
using data from the Istanbul Stock Exchange (ISE). Characterized by the absence of option
trading for its stocks and relatively high transaction costs, the ISE provides a suitable
setting for examining this claim. Overall, the results give moderate support to this
argument. Nonetheless, they show that relatively large positive excess returns are available
around short trading periods of between one and two months. None of the potential
explanations considered, namely the level of transaction costs, the systematic risk of the
pairs portfolio and the existence of short term mean reversion in stock returns, can explain
the positive profits for short trading periods.