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Risk Adjustment and Trading Strategies

Dong‐Hyun Ahn1; Jennifer Conrad1; Robert F. Dittmar2

1 University of North Carolina at Chapel Hill · 2 Indiana University

Review of Financial Studies 2003

We assess the profitability of momentum strategies using a stochastic discount factor approach. In unconditional tests, approximately half of the strategies' profitability is explained. In conditional tests we see a further slight decline in profits. We argue that the risk of these strategies should be increasing in the market risk premium. Empirically, while their risk measures estimated relative to the stochastic discount factor behave as predicted, market betas do not; thus capital asset pricing model (CAPM)-like benchmarks may lead to incorrect inferences. Given that our nonparametric risk adjustment explains roughly half of momentum strategy profits, we cannot rule out the possibility of residual mispricing.

DOI
10.1093/rfs/hhg001
Volume
16 (2)
Pages
459-485
Language
en
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