Pairs trading and asset pricing

Existing work on pairs trading do not detail how the variables selected explain the cross section of stock returns. We evaluate whether these variables contribute to the dynamics of the equity risk premium for a broadly diversified portfolio of Chinese stocks. Based on pairs trading strategy, several arbitrage-related factors are proposed. In an equilibrium exchange economy, where the idiosyncratic component of the stock return is modeled as per the Ornstein-Uhlenbeck process, the equity risk premium is obtained from a consumption-based asset pricing model. Sorting individual stocks into portfolios based on a single factor, a long-short strategy is formed by buying and selling stocks in the highest and lowest quintiles, respectively. The differences in the subsequent extreme portfolio return are economically large and highly statistically significant. These differences remain significant after controlling for other documented firm characteristics and explanatory variables in the Fama-Macbeth regressions and double sorting.