Chapter 2
Mean Reversion
What Is Mean Reversion and How Does It Help Us?
Mean reversion is one of the most fundamental concepts underpinning relative value analysis. But while mean reversion is widely understood at an intuitive level, surprisingly few analysts are familiar with the specific tools available for characterizing mean-reverting processes.
In this chapter, we discuss some of the key characteristics of mean-reverting processes and the mean reversion tools that can be used to identify attractive trading opportunities. In particular, we address:
- model selection;
- model estimation;
- calculating conditional expectations and probabilities;
- calculating ex ante risk-adjusted returns, particularly Sharpe ratios;
- calculating first passage times, ...
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