Does financial distress risk drive the momentum anomaly? -Evidence from the U.S. market

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School of Economics | Master's thesis
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PURPOSE OF THE STUDY The main objective of this thesis is to test whether the momentum effect is driven by financial distress risk, a new theory which has been recently proposed by Agarwal and Taffler (2008) in their UK-based study, using data collected from U.S. manufacturing industry. Furthermore, this thesis also investigates the existence of a link between distress risk and other two market anomalies, i.e. size effect and value effect, which has been suggested but not fully agreed in previous papers. Altman’s (1968) z-score bankruptcy prediction model is specifically chosen to determine sample firm’s financial health status, and all the tests in this study are conducted on this basis. DATA The data set used in this thesis consists of all American manufacturing firms listed on NYSE, AMEX and NASDAQ with assets over $ 1 million. All accounting data and stock market data are retrieved from Thomson ONE Bank database. Other market index data (market return, one-month T-bill rate, return on size factor and book-to-market factor) is retrieved from Professor Kenneth R. French’s website. 20-year period is covered in this study starting from June 1989 through June 2009. RESULTS The sample-based evidence obtained in this paper is found inconsistent with Agarwal and Taffler’s (2008) argument. More specifically, although the market underreaction to financial distress risk is proved and the momentum effect phenomenon is found, my results do not show that the momentum effect vanishes after financial distress risk factor gets controlled – the momentum effect is not proxying for financial distress risk. On this basis, I have to conclude that Agarwal and Taffler’s (2008) new theory regarding the relationship between momentum effect and distress risk is not applicable on the U.S. market. In addition, I found no evidence to suggest firm size and book-to-market equity are capturing distress risk.
Altman’s z-score, financial distress risk, market underreaction, momentum effect
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