FRM Part II · FRM Exam Part II · Factors
A risk manager reviews a momentum strategy that buys the past 12-month winners (skipping the most recent month) and sells the losers. After a sharp market rebound following a prolonged crash, the strategy suffers a severe loss. Which explanation best fits the known behaviour of momentum?
Momentum crashes occur because, after a market decline, the loser portfolio is high beta. In a sharp rebound these losers rally strongly, so the short leg incurs large losses. This gives momentum strategies negative skewness and crash risk during market reversals.
- ALosers have high beta in the rebound and outperform, so the short leg loses heavily, producing momentum crashesCorrect
- BWinners have low beta in rebounds, so the long leg earns negative returns, which is a standard feature of value stocks
- CMomentum returns are driven by size, so small-cap underperformance caused the loss
- DMomentum is a pure low-volatility strategy that cannot lose in rebounds
Explanation
After market declines, past losers tend to be high-beta stocks. In a sharp rebound they rally strongly, so the short leg of the momentum portfolio loses heavily, creating negative skewness and crash risk. The other options misattribute the cause.
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