Representative Bias and Pairs Trade: Evidence From S&P 500 and Russell 2000 Indexes

Abstract

This study tests whether pairs trade conditional on representative bias in the options and stock markets leads to abnormal returns. While previous literature on representativeness focuses on a single index, S&P 500 and Russell 2000 indexes are used to examine the extent to which representative bias arises due to a pattern of similar information shock in the three analyzed periods. The empirical results of the options market lend little support to the representativeness anomalies because Russell 2000 index, relative to S&P 500 index, does not adjust to a sequence of information shocks in the 2020 economic downturn inflicted by the coronavirus pandemic, despite the asymmetrical responsiveness to information shock over the sample period of 2004 to 2020, and during the 2008 global financial crisis. However, the empirical findings of the stock market verify, to some degree, the existence of representative bias during the sample period of 2004 to 2020. To examine whether asymmetrical representativeness in the options market or representativeness in the stock market yields abnormal returns, pairs trade is designed to exploit riskless profits via buying S&P 500 index and selling Russell 2000 index. Based on the Fama and French three-factor model, the empirical evidence is in support of market efficiency because the pairs trading strategy cannot generate positive abnormal returns in both options and stock markets.