How Credit Risks Affect Momentum Strategies Returns

Credit risk is the probability of loss from a borrower or counterparty. It is also known as default risk and refers to the potential that an entity may not be able to meet its obligations when due. Credit risk can arise from various sources including individual borrowers, companies, government entities, and even entire countries.

One of the most popular models to measure the credit risk of a company is the Merton model.  Developed by Nobel Laureate Robert Merton, the model is used to measure and evaluate the potential of a company's default risk. It uses quantitative models and input parameters, such as the company's equity value, debt structure, and volatility of asset returns to calculate the probability that a firm will default on its financial obligations.

Reference [1] examined how credit risks impact momentum strategies in the equity market. It utilized the distance to default (DD) from the Kealhofer, McQuown, and Vasicek (KMV) model, a variant of the Merton model, as a proxy of credit risk. It pointed out,

Returns from momentum and contrarian strategies remain one of the most persistent anomalies for the stock market. We examine the influence of credit risk (low, medium, and high) on momentum and contrarian returns in the stock markets of Pakistan, India, and Bangladesh. We find that momentum and contrarian profits exist in the stock markets in all three countries. This implies that when a firm bears high credit risk, then by applying momentum and contrarian strategies on these stocks, the investor can generate excess return of their investment. The results follow the investment theory that if a portfolio expects to generate high return, there is a need to bear higher risk. We further find that in the case of medium credit risk, investors can generate excessive returns by applying momentum and contrarian strategies. There are no relationships among low credit risk and momentum and contrarian returns.

In short, credit risks affect equity momentum strategy returns.

The authors also proposed an investment strategy based on credit risks,

The results suggest that when making the investment through momentum and contrarian strategies, investors should also consider the credit risk of the stock. Furthermore, investors should focus more on high and medium credit risk when making investment strategies because high and medium credit risk of firms provide investors opportunities to generate excessive returns.

We find the results interesting. It’d be useful to see how applicable the results are to the US and other developed markets.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Ahmed Imran Hunjra, Tahar Tayachi, Rashid Mehmood, Sidra Malik and Zoya Malik, Impact of Credit Risk on Momentum and Contrarian Strategies: Evidence from South Asian Markets, Risks 2020, 8(2), 37

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