Investment-Specific Shocks and Momentum Profits

Abstract:     
This paper explores the relationship between investment-specific shocks (i.e., technological innovations in equipment and software), firm investment, and momentum profits. Empirically, momentum profits comove positively with investment-specific shocks with a correlation coefficient of 0.32. An unconditional two-factor model, with investment-specific shocks and market excess returns as the risk factors, explains 90% of the average returns of momentum portfolios. Consistent with investment dynamics, I propose a rational explanation for momentum profits: Past winners are those who had good idiosyncratic productivity in the recent past; they initiate more investment, make greater investment commitments, and hence have a higher risk exposure to investment-specific shocks than past losers. A simple investment-based asset pricing model is developed to elaborate this story, with the key ingredients of investment commitment and investment-specific shocks. The model generates reasonably large momentum profits and investment dynamics of momentum portfolios as in the data.

Number of Pages in PDF File: 51

Keywords: Momentum, Investment-specific shocks, Investment commitment, Investment-based asset pricing

JEL Classification: G12, E44

working papers series