Work detail

Does trading strategy based on overreaction and stock-bond decoupling generate additional profits?

Author: Mgr. Martin Bosák
Year: 2022 - winter
Leaders: PhDr. František Čech Ph.D.
Consultants:
Work type: Finance, Financial Markets and Banking
Masters
Language: English
Pages: 80
Awards and prizes:
Link: https://dspace.cuni.cz/handle/20.500.11956/171357
Abstract: Studying whether new trading rules provide higher returns than the buy-and-hold strategy is
relevant for both finance theory and the asset management field. In this thesis, we examine the
profitability of the newly proposed trading strategy based on the concept of price overreaction on
eight developed stock indices. In comparison to other studies, we extend a definition of price
overreaction with an inclusion of a minimum volatility threshold. Based on the Ordinary Least
Squares model, we find that a volatility condition significantly improves the predictability of return
reversals after positive price overreaction. For comparison with the buy-and-hold, we use Hansen’s
Superior Predictive Ability test that corrects the data snooping bias. Despite better annualised
returns during in-sample and out-of-sample periods, the results show that the proposed strategy is
not superior to the buy-and-hold at any stock index due to heavy reliance on the predictions of the
largest declines. Nevertheless, we confirm the effect of decoupling (flight to quality) that can
positively affect our strategy, but only when we do not take into account transaction costs. In the
end, we summarize behavioural concepts that lie behind our strategy as the overreaction and
decoupling are mostly justified with cognitive biases.

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