Skewness Preference, Range-based Expectations, and Stock Market Momentum

19 Pages Posted: 28 Mar 2022

See all articles by Soroush Ghazi

Soroush Ghazi

University of Alabama - Department of Economics, Finance and Legal Studies

Mark Schneider

University of Alabama - Department of Economics, Finance and Legal Studies

Date Written: February 27, 2022

Abstract

Momentum is a pervasive characteristic of financial markets that lacks a broadly accepted explanation. In addition to its longstanding challenge to asset pricing theory, recent work finds that momentum poses a challenge for expected utility (EU) theory, opening an avenue for new decision theoretic explanations. In this paper, we provide a new decision theoretic and equilibrium foundation for momentum in stock returns. We consider a representative agent who exhibits a disciplined deviation from EU (exhibiting a preference for positively skewed returns), and who exhibits a disciplined deviation from rational expectations (exhibiting range-based expectations in which an asset is expected to trade next period within its price range over the past year). In a general equilibrium setting that generalizes the classical consumption capital asset pricing model, our representative agent economy exhibits momentum in stock returns. Momentum arises from a new mechanism in which the representative agent truncates the tails of the distribution at an asset's historical trading range. Consequently, a current price near the bottom (top) of the trading range is perceived by the agent as more positively (negatively) skewed, which by skewness preference has lower (higher) subsequent average returns. We conduct a simulation where the agent's preference parameters are calibrated to prior experimental estimates and show quantitatively that the model generates a sizeable momentum premium as in the data. We further provide an aggregation result in which the same asset prices arise in equilibrium from an economy with some behavioral agents (exhibiting skewness preference) and some traditional EU agents.

Keywords: skewness preference, momentum, ranged-based expectation, efficient market hypothesis

JEL Classification: D81, G12, G14, G40

Suggested Citation

Ghazi, Soroush and Schneider, Mark, Skewness Preference, Range-based Expectations, and Stock Market Momentum (February 27, 2022). Available at SSRN: https://ssrn.com/abstract=4045150 or http://dx.doi.org/10.2139/ssrn.4045150

Soroush Ghazi (Contact Author)

University of Alabama - Department of Economics, Finance and Legal Studies ( email )

P.O. Box 870244
Tuscaloosa, AL 35487
United States

HOME PAGE: http://sites.google.com/view/soroush-ghazi

Mark Schneider

University of Alabama - Department of Economics, Finance and Legal Studies ( email )

361 Stadium Dr, Ste 200
Tuscaloosa, AL 35487
United States

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