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Time-varying expected momentum profits
Institution:1. Business School, Korea University, Seoul, Republic of Korea;2. Graduate School of Finance, Korea Advanced Institute of Science and Technology (KAIST), Seoul, Republic of Korea;3. Institute of Financial Analysis, University of Neuchatel, Neuchatel, Switzerland;1. Cranfield School of Management, Cranfield University, Cranfield MK43 0AL, UK;2. The Sir John Cass Business School, City University, London, UK;3. Surrey Business School, University of Surrey, Guildford GU2 7XH, UK;1. Institut de statistique, biostatistique et sciences actuarielles (ISBA), Université Catholique de Louvain, Louvain-la-Neuve, Belgium;2. Graduate Institute of Finance, National Taiwan University of Science and Technology, Taiwan;3. Department of Finance, National Taiwan University, Taiwan;1. Citizens Financial Group, United States;2. Credit Suisse, United States;3. EDHEC Business School, Nice, France;1. School of Finance, Nankai University, 38 Tongyan Road, Jinnan District, Tianjin 300350, China;2. Department of Finance, National Kaohsiung First University of Science and Technology, Kaohsiung, Taiwan;3. Risk and Insurance Research Center, College of Commerce, National Chengchi University, Taiwan;4. Department of Statistics and Actuarial Science, University of Waterloo, 200 University Avenue West, Waterloo N2L 3G1, ON, Canada;1. College of Management, Innovation Center for Big Data and Digital Convergence, Yuan Ze University, Chung-Li, Taiwan;2. School of Accounting, Economics, and Finance, Deakin University, Burwood, Victoria, Australia;3. Department of Finance, National University of Kaohsiung, Kaohsiung, Taiwan;1. School of Economics and Management at Tongji University, Shanghai, China;2. Nanyang Business School, Nanyang Technological University, Singapore, Singapore
Abstract:This paper examines the time variations of expected momentum profits using a two-state Markov switching model with time-varying transition probabilities to evaluate the empirical relevance of recent rational theories of momentum profits. We find that in the expansion state the expected returns of winner stocks are more affected by aggregate economic conditions than those of loser stocks, while in the recession state the expected returns of loser stocks are more affected than those of winner stocks. Consequently, expected momentum profits display strong procyclical variations. We argue that the observed momentum profits are the realization of such expected returns and can be interpreted as the procyclicality premium. We provide a plausible explanation for time-varying momentum profits through the differential effect of leverage and growth options across business cycles.
Keywords:Momentum  Time-varying expected returns  Markov switching regression model  Business cycle  Procyclicality  Growth options
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