Explanation:
The correct answer is A.
Mean reversion theory suggests that prices and returns will eventually move back to their mean or average level. In the context of short-term rates, when these rates are below their long-term equilibrium, the drift (or the expected change in the rate) is positive. This positive drift pushes the rate upwards, moving it closer to the long-term equilibrium value. Conversely, when the short-term rate is above its long-term equilibrium, the drift is negative. This negative drift pulls the rate downwards, moving it closer to the long-term equilibrium. Therefore, choice A accurately describes the behavior of short-term rates under the mean reversion theory.
Choice B is incorrect. According to the mean reversion theory, when the short-term rate falls below the long-term equilibrium, the drift would be positive to move it back towards equilibrium. Conversely, if it rises above the long-term equilibrium, a negative drift would bring it back down. Therefore, this choice contradicts with mean reversion theory.
Choice C is incorrect. The assumption of parallel slope does not apply in this context as we are discussing about mean reversion of short term rates towards long term equilibrium and not about changes in yield curve slopes.
Choice D is incorrect. While economic and financial conditions can influence short-term rates, they do not negate or override the concept of mean reversion which posits that prices and returns will eventually move back to their average level irrespective of these conditions.
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Q.1660 Mean reversion is the theory in finance which assumes that returns and prices will solely get back to their mean or average values. This mean (or average value) can be determined based on the historical average or average returns and prices of that industrial sector. Assuming that the short-term rate is characterized by mean reversion, what will be the effect on the rate if: (I) it is below long-term equilibrium; and (II) if it is above long-term equilibrium?
A
(I) The drift is positive, moving the rate up toward the long term value; (II) The drift is negative, moving the rate down towards the long-term value.
B
(I) The drift is negative, moving the rate down towards the long term value; (II) The drift is positive, moving the rate up toward the long-term value.
C
The drift is parallel based on parallel slope assumption and will behave irrespective of changes in the long-term equilibrium.
D
Short term rates will change with the changes in the economic and financial condition of that industrial sector irrespective of the changes in long-term values.