ABSTRACT We introduce a state‐dependent hedging framework for pairs trading that captures the nonlinear return dependence between stocks and their benchmarks. We reinterpret static pairs trading as a strategy with a state‐dependent hedge ratio that varies with return volatility. This design enables investors to over‐hedge against large return shocks. The augmented strategy shows comparable investment performance but lower downside risk, with pronounced outperformance in recent and highly volatile periods. The strategy's effectiveness appears to stem from managing cash‐flow risks tied to turbulent relative price spreads and maintaining exposure to industry momentum.
Kim et al. (Thu,) studied this question.