Endogenous bubbles in an equilibrium model of rational and noise traders without strategy switching
AbstractWe introduce a model of financial bubbles with two assets (risky and risk-free), in which rational investors and noise traders co-exist. Rational investors form expectations on the return and risk of a risky asset and maximize their expected utility with respect to their allocation on the risky asset versus the risk-free asset. Noise traders are subjected to social imitation and follow momentum trading. By contrast to previous models in the field, we do not allow agents to switch between trading strategies. Allowing for random time-varying herding propensity, we are able to reproduce several stylized facts of financial markets such as a fat-tail distribution of returns, volatility clustering and transient faster-than-exponential bubble growth with approximate log-periodic behavior. The model accounts well for the behavior of traders and for the price dynamics that developed during the dotcom bubble in 1995-2000. Momentum strategies are shown to be transiently profitable, supporting these strategies as enhancing herding behavior.
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Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1109.4726.
Date of creation: Sep 2011
Date of revision: Aug 2013
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