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How to grow a bubble: A model of myopic adapting agents

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  • Georges Harras
  • Didier Sornette

Abstract

We present a simple agent-based model to study the development of a bubble and the consequential crash and investigate how their proximate triggering factor might relate to their fundamental mechanism, and vice versa. Our agents invest according to their opinion on future price movements, which is based on three sources of information, (i) public information, i.e. news, (ii) information from their "friendship" network and (iii) private information. Our bounded rational agents continuously adapt their trading strategy to the current market regime by weighting each of these sources of information in their trading decision according to its recent predicting performance. We find that bubbles originate from a random lucky streak of positive news, which, due to a feedback mechanism of these news on the agents' strategies develop into a transient collective herding regime. After this self-amplified exuberance, the price has reached an unsustainable high value, being corrected by a crash, which brings the price even below its fundamental value. These ingredients provide a simple mechanism for the excess volatility documented in financial markets. Paradoxically, it is the attempt for investors to adapt to the current market regime which leads to a dramatic amplification of the price volatility. A positive feedback loop is created by the two dominating mechanisms (adaptation and imitation) which, by reinforcing each other, result in bubbles and crashes. The model offers a simple reconciliation of the two opposite (herding versus fundamental) proposals for the origin of crashes within a single framework and justifies the existence of two populations in the distribution of returns, exemplifying the concept that crashes are qualitatively different from the rest of the price moves.

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Paper provided by arXiv.org in its series Papers with number 0806.2989.

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Date of creation: Jun 2008
Date of revision: Nov 2010
Handle: RePEc:arx:papers:0806.2989

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Cited by:
  1. Mark Setterfield & Bill Gibson, 2013. "Real and financial crises: A multi-agent approach," Working Papers, Trinity College, Department of Economics 1309, Trinity College, Department of Economics, revised Jul 2014.
  2. T. Kaizoji & M. Leiss & A. Saichev & D. Sornette, 2011. "Super-exponential endogenous bubbles in an equilibrium model of rational and noise traders," Papers 1109.4726, arXiv.org, revised Mar 2014.
  3. Liudmila G. Egorova, 2014. "The Effectiveness Of Different Trading Strategies For Price-Takers," HSE Working papers, National Research University Higher School of Economics WP BRP 29/FE/2014, National Research University Higher School of Economics.
  4. Krause, Sebastian M. & Bornholdt, Stefan, 2013. "Spin models as microfoundation of macroscopic market models," Physica A: Statistical Mechanics and its Applications, Elsevier, Elsevier, vol. 392(18), pages 4048-4054.
  5. D. Sornette, 2014. "Physics and Financial Economics (1776-2014): Puzzles, Ising and Agent-Based models," Papers 1404.0243, arXiv.org.
  6. Jean-Philippe Bouchaud, 2012. "Crises and collective socio-economic phenomena: simple models and challenges," Papers 1209.0453, arXiv.org, revised Dec 2012.

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