NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Tail Risk in Momentum Strategy Returns

Kent Daniel, Ravi Jagannathan, Soohun Kim

NBER Working Paper No. 18169
Issued in June 2012
NBER Program(s):   AP

Momentum strategy returns are highly left skewed and leptokurtic. We explain this by the leverage dynamics of stocks in the momentum portfolio: under certain conditions past losers become highly levered, embedding a call option on the market. Based on this insight, we develop a hidden Markov model (HMM) that identifies such times when large losses are more likely using the convex relation between momentum and market returns. The estimated HMM predicts momentum strategy tail events better than alternative models both in- and out-of-sample. The dramatic momentum crashes result from this time-varying interaction with market returns, and not black-Swan like shocks.

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This paper was revised on June 1, 2016

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Document Object Identifier (DOI): 10.3386/w18169

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