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The impact of time-varying idiosyncratic risk and trading costs on momentum and value strategies

Li, X. (2008). The impact of time-varying idiosyncratic risk and trading costs on momentum and value strategies. (Unpublished Doctoral thesis, City University London)


Recent research has discussed the possible role of idiosyncratic risk in explaining equity returns. Simultaneously, but somehow independently, numerous other studies have documented the failure ofthe static and conditional capital asset pricing models to explain momentum profits and the value premium The first and second parts ,of this study assess whether the widely documented momentum profits and post-1963 value premium can be attributed to time-varying idiosyncratic risk as described by a GJR-GARCH(l,I)-M model. In accordance with existing studies, we find that the static CAPM has no explanatory power for momentum profits and the value premium, and that firm size has only a limited role to play. The results show that momentum profits are a compensation for time-varying idiosyncratic risk. In addition, negative return shocks. increase the volatility of losers, more than they increase that of winners, and the volatility of the losers responds to news more slowly, but eventually to a greater extent, than that of the winners. The post-1963 value premium can be fully captured' by the conditional variance I specification incorporating time-varying idiosyncratic risk as well. The value premium is a compensation for exposure to ti~e-varying risk. This conclusion is robust to different characteristics of value and growth stocks and to the countries under review (US and UK). The third part ofthis stu~y analyses the impact of trading costs on the profitability of momentum strategies in the UK. It finds that losers are more expensive to trade than winners due to the high selling cost of loser stocks that can be characterized as small size and low trading volume stocks. It proposes a new low-cost momentum strategy by selecting winner and loser stocks with the lowest total transaction costs. While the study severely questions the profitability of standard momentum strategies, it shows that there is still room for momentum-based return enhancement, should asset managers decide to adopt low-cost momentum strategies

Publication Type: Thesis (Doctoral)
Subjects: H Social Sciences > HG Finance
Departments: Bayes Business School > Finance
Doctoral Theses
Bayes Business School > Bayes Business School Doctoral Theses
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