Mean reversion is best applied to value a quantity that is not likely to go “beyond a point of no return”. For example, in currencies we can say, with a fair degree of confidence, that no major currency is going to collapse in the short to medium term – we can’t say that for smaller exotic currencies like the Zimbabwean Dollar.
The best analogy to mean reversion in the real world is a stretched spring, or a rubber band – we expect both of these to return to their natural positions once the external forces (or factors) acting on them are removed. In these cases a point of no return will come about if we were to stretch the spring beyond a position from which it can’t recover, or to stretch the rubber band enough to tear it apart. In summary, the working assumption for the mean reversion theory is that the underlying asset will not exceed some undefined point of no return.
I have applied mean reversion by first calculating a 250-day moving average (going backwards from most recent values) . And second, to take the ratio of spot value / average value. Finally I plotted the trends and worked out how many times did the current valuation ratio was breached in the past – this tells us the likelihood of the current ratio being stretched further.
My results, as of 4th October 2011, show that currently the most stretched currency pair is the Canadian dollar versus the US Dollar. Usd/Cad ratio shows that it has only been exceed on 1.4% of all daily trading days. The South African Rand, Usd/Zar is the next most stretched pair, having only exceeded the present ratio on 5.8% of all occasions. The plot below shows Rand valuations.
Source | The Currency Forecasting Blog (CFB) | http://currency-forecasting.blogspot.com/2011/10/mean-reversion-which-currency-is.html
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