Default probability anomalies in the momentum strategies

Abstract

This study examines the usefulness of default probability (DP) in explaining momentum profits. We follow Merton (1974) in computing the DP and then follow Jegadeesh and Titman (1993) in conducting default momentum investing. We consider emerging Taiwanese stock market and divide its stocks into three DP groups. Our findings show that adding DP to momentum investing leads to an increase in momentum profits, suggesting that momentum pay-off increases as DP increases. Moreover, a significant and positive momentum profit of buying winners in the high-DP group and selling losers in the low-DP group is observed, implying that DP anomalies exit in momentum strategies. These findings shed light on the source of profitability of momentum strategies.

Keywords:

• momentum
• default probability
• Merton options
• anomalies

JEL Classification:

• C51
• G10
• E44

Notes

¹ Following Merton (1974), we solve the nonlinear system of and to obtain V_A and σ_A where and . Furthermore, in the Black and Scholes (1973) model, the time path of the market value of assets follows a stochastic process, and the distance of the asset value V_A, _T from the default point X is then defined as the distance. Finally, we compute the default probability (DP).

² The Taiwan Stock Exchange (TWSE) is the 20th largest stock market in the world with market capitalization of approximately US$735 billion on 31 December 2012 according to monthly reports by the World Federation of Exchanges on the website http://www.world-exchanges.org/. Additionally, the GTSM is similar to its fellow exchange, the TWSE. As reported by GTSM, one-third of the listed companies (approximately 118) on the GTSM announced their EPS higher than 3 in 2012.