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FRM Part II · FRM Exam Part II · Factor Theory

During a sharp market rebound after a prolonged crisis, a momentum strategy that was long prior winners and short prior losers suffers large losses. Which explanation is most consistent with the known risk characteristics of momentum?

Momentum tends to crash in sharp rebounds after market declines, because past losers, often high-beta stocks, rally strongly and the short leg loses heavily. This gives momentum negative skewness despite its attractive average return.

  1. AMomentum is prone to crashes in rebounds because past losers, which tend to be high-beta, rally strongly while the short position losesCorrect
  2. BMomentum crashes occur because value stocks are always overpriced after crises
  3. CMomentum losses arise because the strategy is long small-cap stocks that are illiquid in rebounds
  4. DMomentum losses arise because the strategy has negative exposure to the size factor by construction

Explanation

Momentum exhibits negative skewness and crashes when markets rebound after declines: the loser portfolio, often high beta, surges, hurting the short leg. The other options invent mechanical relationships between momentum and value or size that do not define the crash behavior.

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