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Rev Fin 2003; 16:459-485
© 2003 the Society for Financial Studies

Risk Adjustment and Trading Strategies

Dong-Hyun Ahn
University of North Carolina–Chapel Hill

Jennifer Conrad
University of North Carolina–Chapel Hill

Robert F. Dittmar
Indiana University

Address correspondence to: Robert Dittmar, Kelley School of Business, Indiana University, 1309 E. Tenth St., Bloomington, IN 47401, or e-mail: rdittmar{at}indiana.edu.

Abstract

We assess the profitability of momentum strategies using a stochastic discount factor approach. In unconditional tests, approximately half of the strategies' profitability is explained. In conditional tests we see a further slight decline in profits. We argue that the risk of these strategies should be increasing in the market risk premium. Empirically, while their risk measures estimated relative to the stochastic discount factor behave as predicted, market betas do not; thus capital asset pricing model (CAPM)-like benchmarks may lead to incorrect inferences. Given that our nonparametric risk adjustment explains roughly half of momentum strategy profits, we cannot rule out the possibility of residual mispricing.


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