Cumulative Prospect Theory and Momentum Crashes: Evidence from Asia

21 Pages Posted: 15 Feb 2014

See all articles by Paul Docherty

Paul Docherty

Monash University

Gareth Hurst

University of Newcastle (Australia)

Date Written: February 14, 2014

Abstract

We provide robust evidence of momentum crashes within the Asian region, which occurred following the Asian financial crisis and the global financial crisis. The probability of a momentum crash is time-varying; it increases after periods of low market returns and high cross-sectional return dispersion when the beta of the zero-investment momentum portfolio becomes negative. Under cumulative prospect theory, investors overweight the probability of a momentum crash when estimating their value function, resulting in the price of “winners” decreasing and future average returns increasing. Consistent with this theory, we show that momentum returns in Asia are substantially lower following periods where the probability of a momentum crash is higher. Therefore, we argue that the negative (positive) skewness of winner (loser) portfolios is priced and may explain the momentum premium.

Keywords: Momentum crash; skewness; cumulative prospect theory.

JEL Classification: G11, G12

Suggested Citation

Docherty, Paul and Hurst, Gareth, Cumulative Prospect Theory and Momentum Crashes: Evidence from Asia (February 14, 2014). Available at SSRN: https://ssrn.com/abstract=2395721 or http://dx.doi.org/10.2139/ssrn.2395721

Paul Docherty (Contact Author)

Monash University ( email )

23 Innovation Walk
Wellington Road
Clayton, Victoria 3800
Australia

Gareth Hurst

University of Newcastle (Australia) ( email )

University Drive
Callaghan, NSW 2308
Australia

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