TRANSITORY MARKET STATES AND THE JOINT OCCURRENCE OF MOMENTUM AND MEAN REVERSION

Authors


  • The authors thank Ashok Abbott, Victor Chow, Strat Douglas, Hui Guo, Kern Kymn, Reza Mahani (the referee), and seminar participants at the Central University of Finance and Economics, the Dalian Institute of Technology, McMaster University, and the 2010 Financial Management Association meetings in New York for valuable comments.

Abstract

In this article we derive and investigate the implications of the Fama–French and Poterba–Summers model—in which the market price of equity contains permanent and temporary components—to explain cross-sectional differences in equity risk premia and returns. Shocks to the transitory component are regarded a Merton risk factor. We obtain estimates from a simple Kalman decomposition of the market price. The transitory component estimate is used in a conditional capital asset pricing model to test implications of the model related to predictability, cross-sectional performance, and the existence of momentum and mean reversion.

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