Tail Risk in Momentum Strategy Returns
Kent D. Daniel
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER)
Northwestern University, Kellogg School of Management, Department of Finance
June 1, 2012
Price momentum strategies have historically generated high positive returns with little systematic risk. However, these strategies also experience infrequent but severe losses. During 13 of the 978 months in our 1929-2010 sample, losses to a US-equity momentum strategy exceed 20 percent per month. We demonstrate that a hidden Markov model in which the market moves between latent "turbulent'' and "calm'' states in a systematic stochastic manner captures these high-loss episodes. The turbulent state is infrequent in our sample: the probability that the hidden state is turbulent is greater than one-half in only 20% of the months in our sample. Yet in each of the 13 severe loss months, the ex-ante probability that the hidden state is turbulent exceeds 70 percent. This strong forecastability accentuates the price momentum puzzle.
Number of Pages in PDF File: 35working papers series
Date posted: June 5, 2012
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