Performance examination of trading strategy based on Stochastic Dominance

The aim of this research is to examine the performance of a trading strategy based on stochastic dominance in Iran’s stock market. To achieve this purpose, we used a sample including the daily returns of the stocks listed on Tehran stock exchange, between 2001 and 2015, and exploited the portfolio study approach. In this way, for each month portfolios are constructed based on second and third degree stochastic dominance, by buying the dominance stocks and selling the dominated ones. Then the performance of this trading strategy is tested with the respect to the obtained alphas from an extended five-factor model. The results show that the arbitrage portfolios based on stochastic dominance produce positive, statistically significant, excess returns. In addition, these returns are robust even after being adjusted to risk premiums (Market, Size, Value, Liquidity and Momentum premiums). Consequently, the results support the fact that the stochastic dominance factor is engaged in pricing of the Tehran stock exchange. Moreover, it is crucial to notice that the potential price distortions related to infrequent trading have an enormous impact on the results of the study.