An Explanation for Momentum With a Rational Model Under Symmetric Information — Evidence From the US and Chinese Equity Markets

Abstract

In this paper, we show that momentum patterns in equity returns can arise even in a parsimonious model with rational investors having symmetric information. The special feature of our model is that investors obtain a signal before observing the true asset payoff. A more favorable signal, however, impacts both the standard deviation of the return and its skewness. Since investors under rational expectations account for the current risk properties of the asset, the risk-adjusted subsequent return is related to the signal and therefore to the previous asset return. Hence, momentum does not need to be an anomaly but can be consistent with informational market efficiency where a higher subsequent return comes from a higher standard deviation of the asset return and/or a more severe negative skewness. Due to this rationale, it can be present in the future even though investors will have no incentive to exploit it. A comparativestatic analysis of our model reveals under which conditions momentum isparticularly in effect. Furthermore, we test our approach on two different equity markets, U.S. and China which are known to be dominated by different types of investors. The structure of the model allows us to identify for which type of investor momentum pattern is especially likely. This outcome provides the basis for a more precise empirical test for the origin of momentum.

Keywords: reason for momentum, market efficiency, rational representative investor, lognormal distribution

JEL Classification: G11, G12