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Pricing of derivatives on mean-reverting assets. Are stock prices and returns are mean reverting or not - Essay Example

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The goal of this paper is not to provide a final answer to the question whether stock prices and returns are mean reverting or not. Instead, the research aims at making investors aware of the economic consequences of mean reverting behavior of stocks. This lies in regard with the Mondale as of 2022. …
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Pricing of derivatives on mean-reverting assets. Are stock prices and returns are mean reverting or not
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Download file to see previous pages 15 3.6 Data Analysis Methods ……………………………………………………. 16 3.7 Summary …………………………………………………………………… 16 CHAPTER 4 ………………………………………………………………………….……. 17 FIGURES ………………………………...………………………………………… 17 4.1 Definition of mean reversion stock prices ……………………………….…….. 17 4.2 Permanent and transitory price components …………………………………… 17 4.3 Properties of multi-period returns ……………………………………….……... 18 4.4 One-period returns ……………………………………………………....…..…. 19 4.5 Multi-period returns ……………………………………………………………. 20 4.6 Higher-order AR model ……………………………………………………….... 22 4.7 The relation between mean reversion and covariance stationary …...………….. 23 CHAPTER 5 …………………………………………………………………………………… 25 5. Mean reversion and mean-variance efficient portfolios …………………………. 25 5.1 Outline ………………………………………………………………………….. 25 5.1.1 Expected returns and volatilities of stocks and bonds ………………... 25 5.1.2 Correlation between stock and bond returns …………………………. 26 5.1.3 Risk-free yield curve …………………………………………………. 26 5.1.4 Variance ratio of permanent and transitory returns …………….…….. 26 5.2 The role of the variance ratio...
Although the mean-reverting price process defined later by Equations (1), (2), and (3) may seem restrictive, they are more general than is apparent at first sight. This generality explains the model’s suitability as a tool for describing the mean reverting behavior of stock prices. To allow the price process to be consistent with the efficient market hypothesis, the random walk should lie nested in the specification for the stock price (Frankel, 1995, 140). This explains why the permanent price component in the first equation lies chosen to be a random walk. The price process in Equation (1) follows a random walk for ø= one, but deviates from the efficient market hypothesis for zero < ø < 1. Hence, only the choice for a first-order autoregressive (AR) process could possibly be restrictive (Bekaert, 1999, 129).

A seemingly more general specification defines zt with regard to the first equation as a covariance-stationary, mean-reverting process with mean 0.But every covariance stationary series can stand written as a moving average (MA) process of infinite order. If the MA process is invertible, it can be written as an AR process of infinite order, which brings us one-step closer to our AR (1) process. The only restrictive aspect of the first-order AR process is its order. We may therefore want to consider a generalization of the previously considered mean reverting price process by relaxing the assumption of a first order AR process for the transitory price component. Instead of an AR (1) process we could assume an AR (p) process as approximation of an AR process of infinite order, for any p= one, 2… (Bekaert, 1999, 65).
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