Investment Under Alternative Return Assumptions: Comparing Random Walks and Mean Reversion
33 Pages Posted: 20 Sep 2000 Last revised: 26 Jun 2010
Date Written: March 1995
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: Suggested Citation