Momentum Effect Empirical Study.pdf

of 97

  • date post

    06-Jul-2018
  • Category

    Documents

  • view

    215
  • download

    0

Embed Size (px)

Transcript of Momentum Effect Empirical Study.pdf

  • 8/17/2019 Momentum Effect Empirical Study.pdf

    1/97

    Master Thesis

    The Momentum Effect on Stock Markets

    - a Literature Review and an Empirical Study -

    M.Sc. Finance and Accounting (Cand.merc.FIR)

    Copenhagen Business School - Institute of Accounting and Auditing

    Author: Maria Eslykke Søndergaard Date of Submission: 12th of July 2010

    Supervisor: Ole Risager Number of Standard Pages: 80

  • 8/17/2019 Momentum Effect Empirical Study.pdf

    2/97

    Master Thesis - M.Sc. Finance and Accounting The Momentum Effect on Stock Markets

    Abstract

    In contrast to the traditional finance theory, stating that predictability of future stock prices

    and identification of continuously profitable trading strategies are impossible, an extensive

     body of finance literature in the 1980’s documents that stock prices are, at least somewhat,

     predictable based on past returns. In 1993, Jegadeesh and Titman publish the first article on

    medium term momentum in stock prices, documenting that, over 3 to 12 months horizons,

     past winners continue to outperform past losers by around 1% per month. A significant

    number of subsequent studies document that the momentum effect is a worldwide

     phenomenon, which is robust across both different types of stocks and time periods.

    Apart from clarifying what has already been documented on momentum strategies, the thesis

    tests whether the momentum effect has existed on the Danish stock market over the period

    from 1996 through 2009, and finds substantial evidence that it has. The momentum returns

    from a total of 16 examined strategies all turn out to be significantly positive with average

    monthly returns ranging from 0.61% to 1.55%. Consistent with previously conducted studies,

    strategies with long formation periods and short holding periods turn out to be the most

    successful. The momentum returns continue to be positive even after accounting for

    transaction costs, and also the momentum effect appears relatively robust across different

    types of stocks and sub-periods.

    From a presentation of possible explanations of the momentum effect, it is found that none of

    the three risk measures from the Three-Factor Model (i.e. beta, size, and book-to-market

    values) are able to account for the observed return pattern. Also explanations related to data

    snooping and flawed methodology seem unfounded due to the many studies documenting the

    momentum effect. The models from behavioural finance, using psychological biases and

    interaction between different investor types, thus appear to provide the best explanations for

    the momentum phenomenon. The behavioural models are, however, many and no single model is found to be superior. One possibility could be that all the models individually

    contribute to explaining the momentum effect, but that different models turn out to be

    superior in different markets or different types of stocks. This hypothesis, however, remains

    to be tested.

    .

  • 8/17/2019 Momentum Effect Empirical Study.pdf

    3/97

    Master Thesis - M.Sc. Finance and Accounting The Momentum Effect on Stock Markets

    Page | 1

    Table of Contents

    1. Introductory Chapter...................................................................................................................................................3 

    1.2. Introduction ........................................................................................................................... 3 

    1.3. Problem Statements ............................................................................................................... 4 

    1.4. Scope ..................................................................................................................................... 4 

    1.5. Thesis Outline ....................................................................................................................... 5 

    1.6. Criticism of Sources .............................................................................................................. 6 

    2. Pricing of Financial Assets - Traditional versus Behavioural Finance ............................. ............................... ....... 7 

    2.1. Traditional Finance Theory ................................................................................................... 7 

    2.1.1. Equilibrium Asset Pricing Models .....................................................................................8 

    2.1.2. The Efficient Market Hypothesis...................................................................................... 11 

    2.1.3. Implications of Traditional Finance Theory .................................................................... 12 

    2.2. Behavioural Finance ............................................................................................................ 13 

    2.2.1. Investor Psychology ........................................................................................................ 13 

    2.2.2. Limits to Arbitrage .......................................................................................................... 15 

    2.2.3. Implications of Behavioural Finance ............................................................................... 16  

    3. Trading Strategies Based on Technical Analysis ...................... .............................. ............................... .................17 

    4. Literature Review of Price Momentum Strategies .............................. ............................... ............................... ..... 19 

    4.1. Commonly Used Test Methodology ................................................................................... 19 

    4.2. Empirical Findings of Momentum Strategies ..................................................................... 20 

    4.2.1. Empirical Studies of the American Stock Market ............................................................. 21 

    4.2.2. Empirical Studies of Other International Stock Markets .................................................. 25 

    4.2.3. Worldwide Study of Momentum Strategies ....................................................................... 32 

    4.2.4. Summary ......................................................................................................................... 33 

    5. An Empirical Study of the Danish Stock Market ................................................. ............................... .................... 34 

    5.1. Fundamentals Preceding the Empirical Analysis ................................................................ 34 

    5.1.1. Sample Period ................................................................................................................ 34 

    5.1.2. Sample Data ................................................................................................................... 35 

    5.1.3. Test Methodology ............................................................................................................ 37  

    5.1.4. Statistical Issues.............................................................................................................. 42 

    5.2. The Momentum Effect on the Danish Stock Market .......................................................... 43 

    5.2.1. Summary ......................................................................................................................... 46  

    5.3. Robustness Tests ................................................................................................................. 46 

    5.3.1. Size-Based Subsamples ................................................................................................... 47  

    5.3.2. Value-Based Subsamples................................................................................................. 48 

    5.3.3. Volume-Based Subsamples .............................................................................................. 50 

    5.3.4. Sub-Period Analysis ........................................................................................................ 51 

  • 8/17/2019 Momentum Effect Empirical Study.pdf

    4/97

    Master Thesis - M.Sc. Finance and Accounting The Momentum Effect on Stock Markets

    Page | 2

    5.3.5. Summary ......................................................................................................................... 54 

    5.4. Practical Implementation Issues .......................................................................................... 55 

    5.4.1. Transaction Costs ........................................................................................................... 55 

    5.4.2. Short-Selling ................................................................................................................... 57  

    5.4.3. Summary ......................................................................................................................... 58 

    6. Momentum Explanations .............................. ................................ ............................... .............................. ............... 59 

    6.1. Risk-Related Explanations .................................................................................................. 59 

    6.2. Data Snooping an