Vayanos, Dimitri and Woolley, Paul (2008) An institutional theory of momentum and reversal. Discussion paper, 621. Financial Markets Group, London School of Economics and Political Science, London, UK.
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We propose a rational theory of momentum and reversal based on delegated portfolio management. A competitive investor can invest through an index fund or an active fund run by a manager with unknown ability. Following a negative cashflow shock to assets held by the active fund, the investor updates negatively about the manager’s ability and migrates to the index fund. While prices of assets held by the active fund drop in anticipation of the investor’s outflows, the drop is expected to continue, leading to momentum. Because outflows push prices below fundamental values, expected returns eventually rise, leading to reversal. Fund flows generate comovement and lead-lag effects, with predictability being stronger for assets with high idiosyncratic risk. We derive explicit solutions for asset prices, within a continuous-time normal-linear equilibrium.
|Item Type:||Monograph (Discussion Paper)|
|Additional Information:||© 2008 The Authors|
|Library of Congress subject classification:||H Social Sciences > HB Economic Theory|
|Journal of Economic Literature Classification System:||E - Macroeconomics and Monetary Economics > E1 - General Aggregative Models > E17 - Forecasting and Simulation|
|Sets:||Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
|Date Deposited:||15 Jul 2009 08:47|
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