A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets

Download or read book A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets written by Harrison G. Hong and published by . This book was released on 2008 with total page 59 pages. Available in PDF, EPUB and Kindle. Book excerpt: We assume that the instantaneous riskless rate reverts towards a central tendency which in turn, is changing stochastically over time. As a result, current short-term rates are notquot; sufficient to predict future short-term rates movements, as would be the case if the centralquot; tendency was constant. However, since longer-maturity bond prices incorporate informationquot; about the central tendency, longer-maturity bond yields can be used to predict future short-termquot; rate movements. We develop a two-factor model of the term-structure which implies that aquot; linear combination of any two rates can be used as a proxy for the central tendency. Based onquot; this central-tendency proxy, we estimate a model of the one-month rate which performs betterquot; than models which assume the central tendency to be constant.