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Tail Risk in Momentum Strategy Returns

Author

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  • Kent Daniel
  • Ravi Jagannathan
  • Soohun Kim

Abstract

Momentum strategies exhibit rare but dramatic losses (crashes), which we show are a result of the leverage dynamics of stocks in the momentum portfolio. When the economy is in a hidden turbulent state associated with a depressed and volatile stock market, the short-side of the momentum portfolio becomes highly levered, and behaves like a call option on the market index portfolio, making momentum crashes more likely. We develop a hidden Markov model of the unobserved turbulent state that affects the returns on the momentum strategy and the market index portfolios. We find that the use of a combination of Normal and Student-t distributions for the hidden residuals in the model to construct the likelihood of the realized momentum and market index returns dramatically improves the models ability to predict crashes. The same variable that forecasts momentum crashes also forecasts the correlation between momentum strategy and value strategy, two of the benchmark investment styles often used in performance appraisal of quant portfolio managers. The correlation is conditionally negative only when the probability of the economy being in a turbulent state is high. The conditional correlation is zero otherwise, which is two thirds of the time. Half of the negative value-momentum relation is due to leverage dynamics of stocks in the momentum strategy portfolio. The other half is due to a hidden risk factor, likely related to funding liquidity identified in Asness et al. (2013), which emerges only when the economy is more likely to be in the turbulent state.

Suggested Citation

  • Kent Daniel & Ravi Jagannathan & Soohun Kim, 2012. "Tail Risk in Momentum Strategy Returns," NBER Working Papers 18169, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:18169
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    Cited by:

    1. Biais, Bruno & Rochet, Jean-Charles & Woolley, Paul, 2013. "The dynamics of innovation and risk," TSE Working Papers 13-448, Toulouse School of Economics (TSE).
    2. Baltzer, Markus & Jank, Stephan & Smajlbegovic, Esad, 2014. "Who trades on momentum?," Discussion Papers 42/2014, Deutsche Bundesbank.
    3. repec:eee:quaeco:v:66:y:2017:i:c:p:240-258 is not listed on IDEAS
    4. Andrew Clare & James Seaton & Peter N. Smith & Stephen Thomas, 2014. "European Equity Investing through the Financial Crisis: Can Risk Parity, Momentum or Trend Following Help to Reduce Tail Risk?," CAMA Working Papers 2014-08, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    5. Tim Bollerslev & Viktor Todorov & Lai Xu, 2014. "Tail Risk Premia and Return Predictability," CREATES Research Papers 2014-49, Department of Economics and Business Economics, Aarhus University.
    6. Clare, Andrew & Seaton, James & Smith, Peter N. & Thomas, Stephen, 2014. "Trend following, risk parity and momentum in commodity futures," International Review of Financial Analysis, Elsevier, vol. 31(C), pages 1-12.
    7. Bollerslev, Tim & Todorov, Viktor & Xu, Lai, 2015. "Tail risk premia and return predictability," Journal of Financial Economics, Elsevier, vol. 118(1), pages 113-134.
    8. Martens, Martin & van Oord, Arco, 2014. "Hedging the time-varying risk exposures of momentum returns," Journal of Empirical Finance, Elsevier, vol. 28(C), pages 78-89.
    9. Chabot, Benjamin & Ghysels, Eric & Jagannathan, Ravi, 2014. "Momentum Trading, Return Chasing and Predictable Crashes," Working Paper Series WP-2014-27, Federal Reserve Bank of Chicago.
    10. Bohl, Martin T. & Czaja, Marc-Gregor & Kaufmann, Philipp, 2016. "Momentum profits, market cycles, and rebounds: Evidence from Germany," The Quarterly Review of Economics and Finance, Elsevier, vol. 61(C), pages 139-159.
    11. Andrew Clare & James Seaton & Peter N. Smith & Stephen Thomas, 2014. "When Growth Beats Value: Removing Tail Risk From Global Equity Momentum Strategies," Discussion Papers 14/09, Department of Economics, University of York.
    12. Mao, Mike Qinghao & Wei, K.C. John, 2014. "Price and earnings momentum: An explanation using return decomposition," Journal of Empirical Finance, Elsevier, vol. 28(C), pages 332-351.
    13. Edgardo Cayón, 2014. "The Effects of Contagion During the Global Financial Crisis in Government-Regulated and Sponsored Assets in Emerging Markets," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 30, June.

    More about this item

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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