Mean reversion in international equity markets and time-varying risk premium

Abstract

Mean reversion is a phenomenon that has been consistently observed and refuted in several studies over the last decades. This study first aims at shedding further light on the issue by assessing mean reversion on recent data in a broad range of international equity markets including developed and emerging markets and international indices provided by MSCI. Variance ratio computations and a novel distribution-free statistical test based on randomization are used on dollar denominated nominal, real and excess returns of these equity markets. The results indicate that mean reversion exists in both developed and emerging countries, albeit its statistical significance is occasionally dubitable. Moreover, firm size and return type exhibit significant effects on the degree of mean reversion. As Turkish market displays a strong mean reversion in the empirical tests, the second part of the thesis aims at identifying the cause of this apparent anomaly. Equity risk premium estimations generated via two-pass cross-sectional regressions reveal that the mean reversion is due to dynamic nature of equity risk-premium. The results indicate that the mean reversion in Turkish equity market is rather a result of time-varying behavior of rational investors than market inefficiency.