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Does Fin Distres Factor Drive the MOM Anomaly

Does Fin Distres Factor Drive the MOM Anomaly

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03/18/2014

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DOES THE FINANCIAL DISTRESS FACTOR DRIVE THE
MOMENTUM ANOMALY?

Vineet Agarwal
and
Richard Taffler*
Cranfield School of Management
Version 9.2: February 28, 2005

Paper presented in the Finance Faculty Seminar Series at City University
(Cass) Business School, London
Wednesday 9th February 2005

*Corresponding author:
Professor Richard Taffler
Cranfield School of Management
Cranfield
Bedford MK43 0AL
U.K.

Tel: 00 44 (0) 1234 754543
Fax: 00 44 (0) 1234 752554
E-mail: R.J.Taffler@cranfield.ac.uk

DOES THE FINANCIAL DISTRESS FACTOR DRIVE THE
MOMENTUM ANOMALY?
Abstract

This paper brings together the evidence on two asset pricing anomalies \u2013 continuation of prior returns (momentum) and the market pricing of distressed firms. Our empirical analysis demonstrates both these effects are driven by market underreaction to bad news, and that momentum is largely subsumed by our distress risk factor. We also extend the extant literature on the market pricing of distress risk by considering this conditional on market state and GDP growth rate, and find little evidence that financial distress risk is a priced risk factor.

1
DOES THE FINANCIAL DISTRESS FACTOR DRIVE THE
MOMENTUM ANOMALY?

The existence of medium term continuation of stock returns (momentum) is widely accepted
in both the academic literature and in the professional investment community. There are several
competing explanations for this most challenging of all anomalies (Fama (1998)). The first is
risk based (e.g., Chan (1988), Ball and Kothari (1989), Zarowin (1990), Conrad and Kaul (1998)
and Chordia and Shivakumar (2002). Jegadeesh and Titman (1993, 2001) and other studies (e.g.,
Daniel and Titman (1999) and Hong, Lim and Stein (2000)) argue momentum is driven by
underreaction to information. Lesmond, Schill and Zhou (2004) provide a market microstructure
argument that apparent momentum profits are explained by small firm transaction costs. The
usual criticism of data mining also applies (Lo and MacKinlay (1990)).

Several behavioral models based on inherent biases in the way investors process information
have also been proposed to explain medium term continuation of returns. In Barberis, Shleifer
and Vishny (1998), investors are slow to update their beliefs in response to new public
information leading to underreaction, and this generates positive autocorrelation in stock returns.
In Hong and Stein (1999), not all investors receive the same information at the same time and, in
addition, investors are unable to extract fully other investors\u2019 private information from market
prices. As news slowly diffuses among the wider investing public, stock prices also adjust slowly
leading to underreaction to new information and positive autocorrelations. The empirical results
of Hong, Lim and Stein (2000) provide evidence supportive of this. Daniel and Titman (1999)
find a significant momentum effect for growth stocks and no effect for value stocks. They

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