Momentum: A Rational Interpretation

Abstract

In this thesis, I examine existing theories that attempt to explain the asset pricing phenomenon known as momentum. I revisit the seminal work of Chordia and Shivakumar (2002); Cooper, Guiterrez and Hameed (2004); and Stivers and Sun (2010). Using an updated sample, I reexamine their findings, while also comparing the results by credit rating. It has been shown that, among rated firms, momentum appears to exist only among firms with a non-investment grade credit rating. By comparing the results of the investment grade firms with those of the non-investment grade firms, we can see which are being driven by firms that experience momentum. The results indicate that momentum is more closely related to the state of the market than the state of the economy. However, among market-state variables, it is the return dispersion within the market that is more important, as opposed to the returns of the market themselves. Return dispersion is negatively related to momentum returns. If return dispersion is considered to be a measure of market uncertainty, then this is inconsistent with many leading behavourial theories that include uncertainty as a driving factor of momentum. In response to this, I present an alternative risk-based explanation that is consistent with these findings, as well as reconcile them with much of the existing empirical evidence supporting these behavioural theories.