Momentum, Risk, and Underreaction

Abstract

Momentum profits can be explained by exposure to risks omitted from common factor models (distress risk, idiosyncratic risk, and covariance with corporate bonds) and underreaction to innovations in these risks. Momentum strategies tend to go long risky stocks with high expected returns. Consistent with risk as a partial explanation of momentum profits, long formation period momentum strategies earn higher returns and are more highly correlated with risk factors than short formation period momentum strategies. Momentum strategies also tend to go short stocks with recent increases in risk; these stocks have low expected returns because investors underreact to risk innovations.

Keywords: Momentum, Risk, Underreaction

JEL Classification: G12, G14