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Financial Markets and Portfolio Management

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07.06.2017

Risks and rewards for momentum and reversal portfolios

verfasst von: Yuming Li

Erschienen in: Financial Markets and Portfolio Management | Ausgabe 3/2017

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Abstract

Rational asset pricing implies a positive relation between the expected risk-adjusted return and the volatility of a factor-mimicking portfolio. The relation for the momentum portfolio is weak after its return is adjusted for the risks associated with the market return, the size factor, and the book-to-market factor. However, the relation is significantly positive and captures most of the average return on the momentum portfolio after the return is adjusted for the market return and the risk associated with the short-term reversal portfolio return. The result supports the hypothesis that there is a common factor underlying both momentum and short-term reversal. The dynamics of the factor loadings and the correlation structure of the underlying factors have important implications for the risk prices associated with the factor-mimicking portfolios and the risk–return trade-off for momentum and reversal portfolios.

Vorheriger Artikel Predictive models for disaggregate stock market volatility

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Kim et al. (2014) provide a plausible explanation for time-varying momentum profits through the differential effect of leverage and growth options across business cycles.

Li et al. (2008) and Chichernea and Slezak (2013) report that momentum profits are a compensation for time-varying unsystematic risks, which are common to the winner and loser stocks but affect the former more than the latter. Since the momentum portfolio is used as a factor-mimicking portfolio in this paper, portfolio risk is considered a systematic risk.

Here, I assume that the loading matrix is invertible, i.e., is nonsingular. This requires the number of factor-mimicking portfolios to be the same as the number of factors.

\(E(R_{it}^a )=E[E_{t-1} (R_{it}^a )]=\frac{\gamma _i }{\beta _{ii} }E[\hbox {var}_{t-1} (R_{it}^a )]\), where \(E[\hbox {var}_{t-1} (R_{it}^a )]>0\). Maio and Santa-Clara (2012) also examine restrictions on the signs of the risk prices implied by Merton’s (1973) ICAPM, based on the predictability of the state variables on future market returns. They find test results to be sensitive to the proxies of the state variables. The approach in this paper offers an alternative and simple way to study the sign restrictions on the risk prices implied by the APT, which is developed under weaker no-arbitrage conditions than those under the ICAPM.

Alternatively, one can assume that the matrices G, A, and D are all diagonal. I find that under the diagonal GARCH process, the four-factor model does not adequately capture the average WML return (average pricing error is significant).

See, e.g., Jaganathan and Wang (1996), Guo et al. (2009), and Maio and Santa-Clara (2012).

Adding two or more intercepts tends to cause estimation difficulty due to the multicollinearity problem.

The LR tests of the restriction on the intercept reject both models, probably because the estimates of risk prices are less significant when an intercept is added.

The risk price associated with WML is insignificant at the \(10\%\) level if it is not orthogonalized to the market return.

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Titel: Risks and rewards for momentum and reversal portfolios
verfasst von: Yuming Li
Publikationsdatum: 07.06.2017
Verlag: Springer US
Erschienen in: Financial Markets and Portfolio Management / Ausgabe 3/2017
Print ISSN: 1934-4554
Elektronische ISSN: 2373-8529
DOI: https://doi.org/10.1007/s11408-017-0293-0

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