Pairs trading in financial stock futures: An empirical investigation in Indian stock markets

Pairs trading is a strategy that relies on the existence of strong arbitrage. For application of this strategy, India offers a unique opportunity as on one side it suffers from weak efficiency and on the other side it became the largest market in terms of equity volume trading. In the absence of any concrete findings in this regard, pairs trading was carried out using futures contracts available on financial stock futures including banks. Using Gatev‘s (2006) methodology and holding periods of maximum two weeks, average positive excess returns of 3.71 percent were produced by the pairs trading portfolio. While systematic market risk, size risk or the value risk could not explain these returns, it may still be premature to attribute these returns only to mean reversion, as it is possible that pairs trading profits may be related to patterns in returns that are known to earn significant profits.