This paper establishes a robust link between momentum and credit rating. Momentum profitability is large and significant among low-grade firms, but it is nonexistent among high-grade firms. The momentum payoffs documented in the literature are generated by low-grade firms that account for less than 4% of the overall market capitalization of rated firms. The momentum payoff differential across credit rating groups is unexplained by firm size, firm age, analyst forecast dispersion, leverage, return volatility, and cash f low volatility.JEGADEESH AND TITMAN (1993) DOCUMENT that the momentum-based trading strategy of buying past winners and selling past losers provides statistically significant and economically large payoffs. The empirical evidence on stock return momentum is intriguing because it points to a violation of weak-form market efficiency. In particular, Fama and French (1996) show that momentum profitability is the only CAPM-related anomaly unexplained by the Fama and French (1993) three-factor model. Moreover, Schwert (2003) demonstrates that market anomalies related to profit opportunities, including the size and value effects in the cross-section of average returns as well as time-series predictability of returns by the dividend yield, typically disappear, reverse, or attenuate following their discovery. In contrast, Titman (2001, 2002) document the profitability of momentum strategies after their initial discovery. The robustness of momentum profitability has generated a variety of explanations, both behavioral and risk based.

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We propose a mean-reverting stochastic process for the market beta. In a simulation study, the proposed model generates significantly more precise beta estimates than GARCH betas, betas conditioned on aggregate or firm-level variables, and rolling regression betas, even when the true betas are generated based on these competing specifications. Our model significantly improves out-of-sample hedging effectiveness. In asset pricing tests, our model provides substantially stronger support for the conditional CAPM relative to competing beta models and helps resolve asset pricing anomalies such as the size, book-to-market, and idiosyncratic volatility effects in the cross section of stock returns.