Mean reversion analysis

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derswap07

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  • Suppose that a manager believes that credit spreads are mean reverting. Below are three issues along with the current spread, the mean (average) spread over the past six months, and the standard deviation of the spread. Assuming that the spreads are normally distributed, which issue is the most likely to be purchased based on mean-reversion analysis?
    Issue
    Current Spread
    Mean Spread for
    Past 6 Months
    Standard Deviation
    of Spread
    A
    110 bps
    85 bps
    25 bps
    B
    124
    100
    10
    C
    130
    110
    15
  • What are the underlying assumptions in using mean-reversion analysis?
 
A. 25bps can pickup.
Underlying assumption: Converge to long-term average.
 
Frank,
This a table already given. This is a EOC Q and it does not make sense to me. The answer has a formula whih does not show up anywherein the text. I am confused.
 
My previous answer miss the volaitility part :(
Need to divide the standard deviation to make a comparsion.
So the answer is B.
The concept is simliar to Sharpe ratio and Roy’s Safety-First Measure.
 
Think: why Sharpe ratio and Roy’s Safety-First Measure divide by std?
 
To adjust the return on risk basis- per unit of risk
 
Exactly. Same here. Portoflio management always need to look at risk.
 
derswap07 wrote:
That’s exactly my point. Why divide by std?
Click to expand...
Another (and more statistical) approach to your question is this: if we standardize the current value for each (subtract off the mean and divide by the standard deviation), we can see which asset is currently the furthest away from its mean (in terms of standard deviations). The one with the largest standardized value is most “unusual” and is more likely to revert towards its mean (they said its mean reverting), since it’s the farthest away.
Plain and simple: You know that the series is mean reverting, so the further away from the mean you are (in terms of standard deviations), the more likely it is that you’ll be heading back that way. Pick it up before the spread contracts.
 
What would the answer if one was choosing a bond to SELL?
 
B) since it has the highest standard deviation away from the mean (2.4 away from mean)
 
But thats for PUCHASING A BOND…my question is on SELLING a bond.
 
For selling a bond, I guess you would have a negative number since current spread would be lower than historical spread but you would still choose the bond with the highest ABSOLUTE standard deviations away from the mean
 
I read somewhere that “you BUY LOW ie buy the one with highest spread per risk and SELL HIGH ie sell one with the smallest spread per risk”. I cant seem to see any examples on SELLING bonds in the CFA I material or Prep providers as all seem to deal with the bonds to BUY instead.
 
Ummm why is sell even being mentioned here ? I made a boo boo if so
 
for selling, i would think it’s the lowest value of (current-mean)/standard deviation as those would have the least price gain from spread reverting to mean.
 
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