The objective of this study is to develop a financially profitable Pairs trading model for trading in Dhaka Stock Exchange. Pairs Trade is a statistical arbitrage investment strategy. The study used daily stock prices of a sample of 20 stocks listed in Dhaka Stock Exchange. The research first identified a pair of stocks whose prices have a long-run equilibrium using Johansen?s test for cointegration. The cointegrated stock pair is then modeled using a Vector Error Correction Model. The residual obtained from the estimated model serves as the guide to implementing Pairs Trading Strategy. The research finally identified three pairs of stocks which have general long-run equilibriums. Based on the residual series of these pairs, we implemented pairs trading strategy for a period of one to two months using real time data but doing hypothetical trading. It generated significant returns for all trades carried out using both in-sample and out-of-sample data. Given that Bangladesh stock market is frequently subjected to unprecedented volatility, a market-neutral investment strategy like Pairs Trading can be a valuable option to retail and institutional investors. We recommend undertaking policy initiatives required to allow investors to utilize this strategy in Bangladesh.
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