The mean reversion stochastic processes applications in risk management petar r. The body of academic literature on longterm mean reversion is more tractable than that on shortterm mean reversion. Evidence and implications, journal of financial economics 22 october 1988, 2760 with l. Poterba and summers 1988 perform variance ratio tests for similarz. Wealth variability falls as wealth rises black 1976, schwert 1988, 1989, and stock prices show mean reversion fama and french 1988, poterba and summers 1988. In fact, the changes we need to explain consumption smoothing are precisely the changes we observe. Cutler d poterba j and summers l speculative dynamics and the role of feedback. James michael poterba department of economics, e52444. Futher suggested by balvers et al 2000 the differrence. The existence of mean reversion in stock prices is subject to much controversy. As an a priori matter, it is cult to argue for assuming that transitory components should oust rapidly. But traders that pay attention to fundamental values of a stock find stocks that are overpriced this way and sell them, thus dropping the price. Poterba and summers 1988, in which price is the combination of a fair value process whose dynamics are an unpredictable random walk and a meanreversion process transient noise, whose motions tend to selfcorrect.
However, as richardson 1993 points out, the significance of these results must be based onz. What are the consequences of predictability in returns for portfolio choice. Mean reversion in macro models 2016 academic web pages. Introduction there have been a large number of studies see among others poterba and summers 1, or spierdijk, bikker and. Fama and french 1988 measured mean reversion indirectly, by regressing k. The primary case for the existence of long term mean reversion was made in two papers published in 1988, one by james poterba and former us treasury secretary larry summers 1, and the other published by eugene fama and kenneth. A mean reversion process implies a straightforward forecast model. He is also the president of the national bureau of economic research, a nonprofit research organization. In a mean reversion process, price will return to its underlying value i. Mean reversion means that expected return falls as wealth rises. Equilibrium price processes, mean reversion, and consumption smoothing abstract motivated by the empirical observation that there exists some degree of mean reversion in asset prices, this paper investigates the timevarying behaviour of the price of risk in a partial equilibrium framework. Fama and french 1988 and poterba and summers 1988 on mean reversion. Radkov abstract in this study we investigate using the mean reversion processes in financial risk management, as they provide an good description of stock price fluctuations and market risks. Fama and french 1988 and poterba and summers 1988 are the rst to doc.
Moreover, we may expect the speed of mean reversion to depend on the economic and political environment. Investor sentiment in the stock market new york university. Evidence and implications national bureau of economic research, 1050 massachusetts ave. Empirical variance ratios of different return horizons are confronted with simulated probability distributions. Secular mean reversion and longrun predictability of the stock market. Poterba is the mitsui professor of economics at mit massachusetts institute of technology. Mean reversion in equilibrium asset prices stephen g. This mean or average can be the historical average of the price or return, or. Fama and french suggest this interpretation as a logi cal possibility, while poterba and summers argue that the serial correlation in returns should be attributed to price fads.
Mean reversion across national stock markets and parametric. One of us attended a meeting of university endowment managers in the aftermath of the market meltdown of 2008. Cutler d poterba j and summers l speculative dynamics and the. Request pdf transitory market states and the joint occurrence of momentum and mean reversion in this article we derive and investigate the implications of the famafrench and poterba. It demonstrates that variance ratios are among the most powerful tests for detecting mean reversion in stock prices, but that they have little power against the principal interesting alternatives to the random walk hypothesis. Poterba and summers 1988 claim, however, that the magnitude of change in interest rates should be very huge to cause mean reversion patterns. To illustrate this, the mean reversion of a credit default swap cds bulgarian 5y index, is tested using the. We develop some properties on the autocorrelation of the kperiod returns for the general mean reversion gmr process in which the stationary component is not restricted to the arl process but take the form of a general arma process. A recentliterature,beginningwith brennan,schwartz,andlagnado1997,camp. The persistence of volatility and stock market fluctuations. Kenneth french as well as james poterba and lawrence summers have managed to detect mean reversion in u. There is related evidence that stock returns exhibit mean reversion. Mean reversion in stock market prices kyiv school of.
Poterba and summers 1988 demonstrate that the variance of stock returns is reduced at longer horizons. New variance ratio tests to identify random walk from the. Summers 1986, campbell and mankiw 1978, fama and french 1988, lo and mackinley 1988 and poterba and summers 1988 report mean reversion in stock returns over time horizons see footnote 1 less than ten years. This paper investigates behavior in monthly and yearly returns at the dutch stock exchange for the period 1947 1992. Evidence and implications, nber working papers 2343, national bureau of economic research, inc. Mean reversion is the theory suggesting that prices and returns eventually move back toward the mean or average. Thaler1985, summers1986, famafrench1988, poterbasummers1988. Poterba and summers 1988, for example, find positive. Whereas theoretical justications for the departure from the random walk model of equity prices have proliferated1, the empirical evidence remains mixed and confusing. Portfolio and consumption decisions under meanreverting.
Their combined citations are counted only for the first article. Summers harvardandnber december1986 revisedaugust1987. Introduction there have been a large number of studies see among others poterba and summers 1. The first part treats methodological issues involved in testing for transitory return components.
See, among others, the studies of fama 1970, summers 1986, poterba and summers. Summers, mean reversion in stock prices previous claims that there are fads in stock prices have typically suggested halflives of several years, implying that the elements in the table corresponding to p12 0. The evidence for mean reversion over long horizons is weaker if the depression years before world war ii are excluded. Selection of a portfolio of pairs based on cointegration. New variance ratio tests to identify random walk from the general mean reversion model abstract. Transitory market states and the joint occurrence of momentum. Secular mean reversion and longrun predictability of the. In this paper, i will propose a stockprice model with meanreverting returns. This study extends the investigation of mean reversion price processes by evaluating the existence of mean reversion in the futures prices of seven. The issues related with mean reversion are addressed using linear. For the purpose of testing mean reversion, only the ratio between.
This paper contributes to the current brazilian literature in behavioural finance by providing an. However, there appears to be substantial mean reversion in nominal and excess returns over the period 18711925. The relationship between market sentiment index and stock. May 15, 2019 mean reversion is the theory suggesting that prices and returns eventually move back toward the mean or average. Apr 30, 2015 in fact, the changes we need to explain consumption smoothing are precisely the changes we observe. Poterba and summers w2343 mean reversion in stock prices. Thaler1985, summers 1986, famafrench1988, poterba summers 1988. Mean reversion in stock prices still remains a rather controversial issue. Summers harvardandnber december1986 revisedaugust1987 wearegratefultobarryperlstein,changyongrhee,jeffzweibelandespecially. Mean reversion refers to a tendency of asset prices to return to a trend path.