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Momentum, Risk, and Underreaction Dynamics

Last Updated on 10 February, 2024 by Rejaul Karim

In the research paper “Momentum, Risk, and Underreaction” by Mark Rachwalski and Quan Wen, the authors explore the relationship between momentum profits and their driving forces.

Specifically, the study examines how exposure to risks that are not considered in common factor models, such as distress risk, idiosyncratic risk, and covariance with corporate bonds, as well as the underreaction to these risk innovations, contribute to explaining momentum profits. They find that momentum strategies tend to adopt long positions in high-risk stocks with considerable expected returns, leading to higher returns and stronger correlations with risk factors in long formation period momentum strategies compared with short formation period strategies.

Furthermore, momentum strategies are inclined to short stocks that have witnessed a recent surge in risk, which subsequently exhibit lower expected returns due to investor underreaction to changes in risk. This paper offers valuable insights on the dynamics of risk factors and investor behavior within the realm of momentum investing.

Abstract Of Paper

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.

Original paper – Download PDF

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Author

Mark Rachwalski
Emory University – Department of Finance

Quan Wen
McDonough School of Business, Georgetown University

Conclusion

In conclusion, the research paper “Momentum, Risk, and Underreaction” by Mark Rachwalski and Quan Wen sheds light on the factors contributing to momentum profits in the world of finance.

The study establishes that these profits can be attributed to exposure to often overlooked risks in common factor models, including distress risk, idiosyncratic risk, and covariance with corporate bonds, as well as investors’ underreaction to innovations in these risks. Findings reveal that momentum strategies tend to favor long positions in high-risk stocks with substantial expected returns, leading to higher returns and stronger correlations with risk factors in long formation period strategies compared to their short formation period counterparts.

Furthermore, the research underscores that momentum strategies tend to short stocks that have recently experienced risk increases, resulting in lower expected returns due to investor underreaction to risk changes. This study offers significant insights into the complex interplay between momentum, risk, and investor behavior in the financial world.

Related Reading:

The Role of Shorting, Firm Size, and Time on Market Anomalies

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FAQ

Q1: What does the research suggest about the driving forces behind momentum profits, and how are these forces related to risk factors?

The research suggests that momentum profits can be explained by exposure to risks not commonly considered in factor models, including distress risk, idiosyncratic risk, and covariance with corporate bonds. The study reveals that momentum strategies tend to adopt long positions in high-risk stocks with significant expected returns, highlighting the relationship between momentum profits and these risk factors.

Q2: How do long and short formation period momentum strategies differ in terms of returns and correlations with risk factors, according to the findings?

Long formation period momentum strategies, which involve going long on stocks with strong past performance, earn higher returns and exhibit stronger correlations with risk factors compared to short formation period strategies. This implies that the dynamics of risk factors play a more pronounced role in explaining momentum profits over longer formation periods.

Q3: What is the role of investor underreaction in the context of momentum strategies, and how does it contribute to the profitability of such strategies?

Investor underreaction to innovations in risk is a crucial factor in the profitability of momentum strategies. The research indicates that momentum strategies tend to short stocks that have recently experienced an increase in risk. These stocks, despite elevated risk, exhibit lower expected returns due to investors’ underreaction to changes in risk. This behavior contributes to the overall profitability of momentum strategies.

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