For those who sat for Level III last year, one AM/PM question had a manager who believed the credit spreads were mean reverting and we were given the different credit spreads vs the mean averances. Normally one picks the bond with the largest difference between current spread and the mean average spread, if the intention is ti BUY a bond. However the question asked which bond is likely to be SOLD based oon rmean reversion analysis. I picked the bond with the lease difference from the mean but i still dont know the answer on this one…can someone help.
Surely when looking for a bond to sell, you would look for a bond with a credit spread below the mean reverting level, in the hope that the spread would increase towards the mean reverting level, resulting in a drop in price.
When you say look for the largest difference between the current spread and the average mean reverting level when looking to buy a bond, surely you mean largest positive difference rather than absolute difference, no?
My take is that you compute the mean credit spread for each of the bonds and for the most appropriate bond to purchase you pick the one with the largest number of standard deviations above its mean. The rationale being that the largest spread will contract the most compared to the other bonds based on mean-reversion.
Not sure though how to deal with the Selling bit.
If spreads were above average, mean reversion would imply putting a narrowing trade, i.e. selling the low-yielding bond vs. buying the high-yielding one. If spreads were below average, then it would be the opposite ie selling the high-yielding bond.