Abstract
We analyze the dependence of future returns on past drawdowns of the monthly time series of the S&P500 index, from 1967 to 2012. From historical data, it appears that when the drawdown increases in absolute value, future returns increase, both in mean as well as in distributional values. We then run a Monte Carlo simulation on three models used in asset pricing, namely the Black-Scholes model, the CEV model and the exponential Ornstein-Uhlenbeck model, to assess whether these models reproduce this drawdown effect. It turns out that, while the first two do not exhibit a dependence of future returns on past drawdowns, in the exponential Ornstein-Uhlenbeck future returns increase when past drawdowns increase in absolute value, consistently with the empirical findings on the S&P500 index.
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