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By Jon Exley, Shyam Mehta and Andrew Smith


Mean reversion exists in many different forms within investment markets, none of these forms is necessarily inconsistent with efficient markets. However, there is a lack of precision in what many investment practitioners mean by the term “mean reversion”. In this paper we review the various forms of this phenomena and both the evidence (if any) and implications (if any) of their existence. In doing so we propose a formal mathematical definition of what most investment practitioners seem to mean by “mean reversion”, based on the correlation of returns between disjoint intervals. We then look at some of the mathematical properties of processes that mean revert (or avert) under our definition and propose a mean reverting (or averting) model that is consistent with a simple form of market efficiency. Finally we review the actuarial implications of adopting mean revering models and highlight some important, and possibly surprising, considerations in using them in a world of market consistent valuations. 1

Year: 2004
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