Abstract
Recent tests of mean reversion in relative stock prices do not acknowledge the fact that relative stock prices can be drifting due to, for example, different risk characteristics of the underlying stock portfolios. Consequently, they impose the wrong form of stationarity. We propose a test for mean reversion in relative stock prices based on the integration of a restricted trend stationarity tests and constrained autoregressive tests. The unified test is superior to the current methodology in two respects. First, it employs the correct form of stationarity. Second, it allows for both partial and full mean reversion of the price differential rather than the currently used restrictive assumption of full mean reversion.
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