An Aumann-Serrano Index Explanation of Short-Term Reversal: Evidence from China

Abstract

Abnormal returns generated from short-term reversal strategy have long been regarded as anomalies as they cannot be explained by traditional financial theory. While this research aims to propose a new risk-based explanation of short-term reversal, and test it by using market data collected from Chinese stock market. We employ the classic Jegadeesh and Titman (1993) method to form reversal portfolios and regress excess returns onto risk factors. Tests results show that short-term reversal strategy captures dynamic risk exposures to the Aumann-Serrano index and other factors, and risk exposures to common factors are sources of reversal profits. From May 2005 to May 2020, reversal portfolio generates a monthly excess return of 2.10% (t-stat=2.14) on average, and extracting risk exposures to risk factors subsequently reduces its profitability to 1.61% (t-stat=1.56) per month. Moreover, combining our model with investor sentiment, we can obtain greater explanatory power, and further explain the reason why short-term reversal strategy in pessimistic periods outperforms optimistic periods.