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Philippe Dupuy, Ph.D, Associate Professor Accounting, Law and Finance Grenoble Ecole de Management

Momentum strategies

Buying assets that have over performed in the recent past.

Jegadeesh and Titman (1993, 2001). Momentum effects tend to persist across equity styles (Fama French factors), across international regional equities.

Based on autocorrelation properties of financial series

Usual strategies: rank assets according to factors (Beta, P/B, P/E,«) and buy first n quintile versus last n quintile (quintile might be overlapping)

Also arbitrages between market indices and cash exhibit autocorrelation. Therefore momentum strategies should work.

Positions in MSCI-EMU are fully financed at EUR Libor 3-month and reset every week (no capitalization).

**Momentum strategies for market index
**

Momentum strategies for indices perform poorly.

The performance of the market (the signal) might be due to size effects (wi), and/or idiosyncratic risk pricing (ei) which have few to do with market or systemic momentum and create noise in the signal.

We apply a methodology to correct this bias (see Kumar Persaud 2001, Gai Vause 2006 and Dupuy 2009) and calculate a pure ³risk appetite´ indicator enabling one to implement momentum strategies on market indices.

Momentum strategies: the signal is the n-week observed return. Positions in MSCI-EMU are fully financed at EUR Libor 3-month and reset every week (no capitalization).

Risk appetite index (RAI)

**Risk appetite index (RAI)
**

The concordance coefficient is independent to the size and sign of past market returns. The RAI might send a ³buy´ signal even in downward trending markets. Similar to high beta-low beta signals but with bounds and idiosyncratic bias removed. More efficient.

Market return (momentum signal) Rt-n > 0 Rt-n < 0

Momentum position

Risk position S>0 Buy Buy

appetite

Risk position S<0 Sell Sell

appetite

Buy Sell

Momentum strategies

Risk appetite based momentum strategies might sell in bull markets and buy in bear markets. They embark a discrete ³contrarian´ functionality.

Delta = 2

Delta = (Mom ± RAI). Delta = 0 same signal. Mom buys, RAI sells. Delta = -2 Mom Sells, RAI buys.

Momentums strategies: risk statistics

Momentum strategies: the signal is the n-week observed return. Risk appetite momentum strategies: the signal is the n-week observed risk appetite. Position in MSCI-EMU are fully financed at EUR Libor 3-month and reset every week (no capitalization).

Momentums strategies: cumulated returns

Momentum strategies (black line): the signal is the n-week observed return. Risk appetite momentum strategies (red line): the signal is the n-week observed risk appetite. Position in MSCI-EMU are fully financed at EUR Libor 3-month and reset every week (no capitalization).

**Time varying returns and Time varying ³systemic only´ returns
**

1. The concordance coefficient might enable one to discern between market movements that were due to the reassessment of systemic and idiosyncratic risk. 2. The absolute value of the coefficient of concordance is a measure of the frequency of cross-sectional market movements that were due to systemic risk pricing. This magnitude lies in between zero and one. 3. Using the concordance coefficient, we are able to generate a series of returns that were only due to systemic risk pricing. the daily return of the market portfolio, Rpt, might be decomposed as follow: Rpt = bt Rpt + (1 í bt ) Rpt with bt = | St | and St the concordance coefficient bt Rpt being the share of the daily return due to systemic risk pricing and by difference (1 í bt ) Rpt being the share of the daily return due to specific risk pricing

**Returns and ³systemic only´ returns
**

we decompose the weekly return of the MSCI EMU into two components: i. the performance due to systemic risk pricing (bt Rpt) ii. the performance due to idiosyncratic risk pricing (1 í bt ) Rpt .

This graph shows the change in the weekly returns of the MSCI EMU (black line) and the change in the estimation of the return of the index that is due to systemic risk pricing, (bt Rpt) (red line). The difference between the two series is the weekly return that is due to specific risk re-pricing (1 í bt ) Rpt.

Returns and ³systemic only´ returns: in 2006 & 2010

2010 2006

Volatility Feedback Strategy: signals

Volatility and ³systemic volatility´

are centered

Thresholds might be set to signal only significant shock of ³systemic volatility´. Hence red signal is often nil. Late buyer in 2008 for relatively ³normal´ amounts. Nearly no trade in 2010 so far.

Volatility feedback hypothesis, Campbell and Hentschel (1992): changes of an index and changes of volatility are positively related on a long term horizon.

Volatility Feedback Strategy: risk statistics

For short-term horizon a strategy based on volatility or a strategy based on ³systemic volatility´ produce similar risk statistics. This strategy tends to work for long term horizon, at the 12-week horizon, a strategy based on ³systemic volatility´ exhibit better statistics. At the 24-week horizon, returns are negative but a strategy based on ³systemic volatility´ seems to offer better protection. Further work would be data mining.

Conclusion

Risk appetite methodologies enable one to discern between returns due to idiosyncratic risk pricing and systemic risk pricing.

Only the systemic share of the returns offers momentum opportunities

Both momentum and volatility feedback strategies risk statistics might be improved using RAI.

These strategies offer usually good diversification properties.

References

Annex: Signals are dependant to the returns ranking period.

Beta are estimated on an equally weighted market return to avoid size effects.

Annex: Signals are independent to the beta ranking period.

Beta are estimated on an equally weighted market return to avoid size effects.

Annex: Risk appetite indicator over the long term = the risk cycle

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