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Bubbles and crashes: Gradient dynamics in financial markets

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Author Info

  • Friedman, Daniel
  • Abraham, Ralph

Abstract

Fund managers respond to the payoff gradient by continuously adjusting leverage in our analytic and simulation models. The base model has a stable equilibrium with classic properties. However, bubbles and crashes occur in extended models incorporating an endogenous market risk premium based on investors' historical losses and constant-gain learning. When losses have been small for a long time, asset prices inflate as fund managers increase leverage. Then slight losses can trigger a crash, as a widening risk premium accelerates deleveraging and asset price declines.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 33 (2009)
Issue (Month): 4 (April)
Pages: 922-937

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Handle: RePEc:eee:dyncon:v:33:y:2009:i:4:p:922-937

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Web page: http://www.elsevier.com/locate/jedc

Related research

Keywords: Bubbles Escape dynamics Time varying risk premium Constant-gain learning Agent-based models;

References

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  1. Friedman, Daniel & Ostrov, Daniel N., 2008. "Conspicuous consumption dynamics," Games and Economic Behavior, Elsevier, vol. 64(1), pages 121-145, September.
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  8. Chevalier, J. & Ellison, G., 1996. "Risk Taking by Mutual Funds as a Response to Incentives," Working papers 96-3, Massachusetts Institute of Technology (MIT), Department of Economics.
  9. Youssefmir, Michael & Huberman, Bernardo A & Hogg, Tad, 1998. "Bubbles and Market Crashes," Computational Economics, Society for Computational Economics, vol. 12(2), pages 97-114, October.
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  18. Stephen F. Le Roy, 2004. "Rational Exuberance," Journal of Economic Literature, American Economic Association, vol. 42(3), pages 783-804, September.
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Citations

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Cited by:
  1. Li, Minqiang, 2008. "A Damped Diffusion Framework for Financial Modeling and Closed-form Maximum Likelihood Estimation," MPRA Paper 11185, University Library of Munich, Germany.
  2. Friedman, Daniel & Ostrov, Daniel N., 2013. "Evolutionary dynamics over continuous action spaces for population games that arise from symmetric two-player games," Journal of Economic Theory, Elsevier, vol. 148(2), pages 743-777.
  3. Bischi, Gian Italo & Lamantia, Fabio, 2012. "A dynamic model of oligopoly with R&D externalities along networks. Part I," Mathematics and Computers in Simulation (MATCOM), Elsevier, vol. 84(C), pages 51-65.
  4. Feldman, Todd, 2011. "Leverage regulation: An agent-based simulation," Journal of Economics and Business, Elsevier, vol. 63(5), pages 431-440, September.
  5. Friedman, Daniel & Isaac, R. Mark & James, Duncan & Sunder, Shyam, 2014. "Risky Curves: On the Empirical Failure of Expected Utility," Santa Cruz Department of Economics, Working Paper Series qt87v8k86z, Department of Economics, UC Santa Cruz.
  6. Feldman, Todd, 2010. "Portfolio manager behavior and global financial crises," Journal of Economic Behavior & Organization, Elsevier, vol. 75(2), pages 192-202, August.

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