Information Percolation, Momentum and Reversal
90 Pages Posted: 30 Oct 2010 Last revised: 25 Mar 2017
Date Written: November 26, 2010
We propose a joint theory of time-series momentum and reversal based on a rational-expectations model. We show that a necessary condition for momentum to arise in this framework is that information flows at an increasing rate. We focus on word-of-mouth communication as a mechanism that enforces this condition and generates short-term momentum and long-term reversal. Investors with heterogeneous trading strategies — contrarian and momentum traders — coexist in the marketplace. Although a significant proportion of investors are momentum traders, momentum is not completely eliminated. Word-of-mouth communication spreads rumors and generates price run-ups and reversals. Our theoretical predictions are in line with empirical findings.
Keywords: Asset pricing; Momentum; Information percolation; Equilibrium
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation