Illuminating the Profitability of Pairs Trading : A Test of Relative Pricing Efficiency of Markets for Water Utility Stocks

This paper examines the profitability of a pairs trading strategy derived solely from historic price dynamics and contrarian principles. We find that the profitability of the self-financing strategy hinges on a cointegrated relationship, which Engle and Granger (1987) show also implies an error-correcting relationship. With an error-correcting relationship at play, our model allows the movement of a temporary pricing flaw back to its expected value to be predicted with a surprisingly high level of accuracy. We find that although we are not be able to foresee the movement of the cointegrating leader, that move generates a predictable response from the cointegrating follower, which the pairs trading strategy is able to profit from. Our results are robust to a variety of scenarios, most interestingly is when the same security is the leader in one combination but the follower in another. In this case, the security in question is predictable only when it is the follower