Productivity, Asset Return, and International Index Momentum
38 Pages Posted: 26 Feb 2008
Date Written: February, 25 2008
This paper first demonstrates that, in a discrete time framework, rational momentum can exist in an economy that has autocorrelated risk and convex dividend policies. It then uses this framework to examine the momentum role of firms. When firms actively create positive productivity shocks and increase overall production scale accordingly, outputs will be convex in productivity. This productivity convexity can generate momentum because a positive productivity shock helps a firm to have both higher realized past return and higher expected return (due to increased exposure to productivity risk). Empirically, productivity-based return components (PBR) usually explain more than 50% of international index momentum return. This result is robust in the presence of other risk factors. Macroeconomic variables also have a certain explanatory power for momentum, partially through PBR. Finally, as a robustness check, PBR also explains about 30% of industry momentum in the US.
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