Dynamic Beta, Time-Varying Risk Premium, and Momentum

Hong Zhang

Yale School of Management Working Papers from Yale School of Management

Abstract: This article proposes a rational model to demonstrate that firm-specific risks can be priced in the equilibrium and can generate asset pricing anomalies such as momentum. In general, business risks at both the market level and firm level can affect a firm's investment decisions, and a firm usually has certain ability to forecast firm-level risks, such as demand changes or technology innovations. When a firm dynamically adjusts its business according to forecasted firm-level risks, investors face a beta risk (which proxies for firm-level risks) in addition to the market risk. These two risks jointly create a nonlinear risk premium, which simultaneously explains momentum and the Fama and French (1993) three-factor model. In other words, momentum profits and the size (value) premium in this model reflect reasonable rewards to compensate investors for the two risks. Empirically, the estimated risk premium contributes a large portion (in many cases a leading portion) of stock momentum profits and help

Date: 2004-06-01, Revised 2005-03-01
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