Investment Under Alternative Return Assumptions: Comparing Random Walks and Mean Reversion

33 Pages Posted: 20 Sep 2000 Last revised: 26 Jun 2010

See all articles by Gilbert E. Metcalf

Gilbert E. Metcalf

Tufts University - Department of Economics; National Bureau of Economic Research (NBER)

Kevin A. Hassett

American Enterprise Institute (AEI)

Date Written: March 1995

Abstract

Many recent theoretical papers have come under attack for modeling prices as Geometric Brownian Motion. This process can diverge over time, implying that firms facing this price process can earn infinite profits. We explore the significance of this attack and contrast investment under Geometric Brownian Motion with investment assuming mean reversion. While analytically more complex, mean reversion in many cases is a more plausible assumption, allowing for supply responses to increasing prices. We show that cumulative investment is generally unaffected by the use of a mean reversion process rather than Geometric Brownian Motion and provide an explanation for this result.

Suggested Citation

Metcalf, Gilbert E. and Hassett, Kevin A., Investment Under Alternative Return Assumptions: Comparing Random Walks and Mean Reversion (March 1995). NBER Working Paper No. t0175. Available at SSRN: https://ssrn.com/abstract=225085

Gilbert E. Metcalf (Contact Author)

Tufts University - Department of Economics ( email )

Medford, MA 02155
United States
617-627-3685 (Phone)
617-627-3917 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Kevin A. Hassett

American Enterprise Institute (AEI) ( email )

1150 17th Street, N.W.
Washington, DC 20036
United States
202.862.7157 (Phone)
202.862.7177 (Fax)

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