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Financial markets as nonlinear adaptive evolutionary systems

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  • C. H. Hommes

Abstract

Recent work on complex adaptive systems for modelling financial markets is surveyed. Financial markets are viewed as evolutionary systems between different, competing trading strategies. Agents are boundedly rational in the sense that they tend to follow strategies that have performed well, according to realized profits or accumulated wealth, in the recent past. Simple technical trading rules may survive evolutionary competition in a heterogeneous world where prices and beliefs coevolve over time. The evolutionary model explains stylized facts, such as fat tails, volatility clustering and long memory, of real financial series. Although our adaptive belief systems are very simple, they can match the autocorrelation patterns of returns, squared returns and absolute returns of 40 years of S&P 500 data. Some recent laboratory work on expectation formation in an asset pricing framework is also discussed.

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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

Volume (Year): 1 (2001)
Issue (Month): 1 ()
Pages: 149-167

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Handle: RePEc:taf:quantf:v:1:y:2001:i:1:p:149-167

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  1. Brock, William & Lakonishok, Josef & LeBaron, Blake, 1992. " Simple Technical Trading Rules and the Stochastic Properties of Stock Returns," Journal of Finance, American Finance Association, vol. 47(5), pages 1731-64, December.
  2. William A. Brock & Blake D. LeBaron, 1995. "A Dynamic Structural Model for Stock Return Volatility and Trading Volume," NBER Working Papers 4988, National Bureau of Economic Research, Inc.
  3. Sunder, S., 1992. "Experimental Asset Markets: A Survey," GSIA Working Papers 1992-19, Carnegie Mellon University, Tepper School of Business.
  4. Farmer, J. Doyne & Joshi, Shareen, 2002. "The price dynamics of common trading strategies," Journal of Economic Behavior & Organization, Elsevier, vol. 49(2), pages 149-171, October.
  5. Carl Chiarella & Xue-Zhong He, 1999. "Heterogeneous Beliefs, Risks and Learning in a Simple Asset Pricing Model," Research Paper Series 18, Quantitative Finance Research Centre, University of Technology, Sydney.
  6. Carl Chiarella, 1992. "The Dynamics of Speculative Behaviour," Working Paper Series 13, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
  7. Baak, Saang Joon, 1999. "Tests for bounded rationality with a linear dynamic model distorted by heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 23(9-10), pages 1517-1543, September.
  8. Wang, Jiang, 1994. "A Model of Competitive Stock Trading Volume," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 127-68, February.
  9. Fama, Eugene F, 1970. "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, American Finance Association, vol. 25(2), pages 383-417, May.
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