Endogenous Correlation

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Endogenous Correlation

Author Info

Yang, J-H.S.
Satchell, S.E.

Abstract

We model endogenous correlation in asset returns via the role of heterogeneous expectations in investor types, and the dynamic impact of imitative learning by investors. Learning is driven by relative performance. In addition, we allow a cautious slow learning pace to reflect institutional conditions. Imitative learning shapes the market ecology that influences price formation. Using the model of non-imitative agents as a benchmark, our results show that the dynamics of imitative learning endogenously induce a significant degree of asset dependency and patterns of non-constant correlation. The asymmetric learning effect on correlation, however, implies a self-reinforcing process, where a bearish condition amplifies the effect that further exacerbates asset dependency. We conclude that imitative learning, even when rational, can to a certain extent account for the phenomena of market crashes. Our results have implications for transparency in regulation issues.

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Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 0321.

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Length: 34
Date of creation: Mar 2003
Date of revision:
Handle: RePEc:cam:camdae:0321

Note: EM (updated August 2003)
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Find related papers by JEL classification:
D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

This paper has been announced in the following NEP Reports:

NEP-ALL-2003-04-02 (All new papers)
NEP-CFN-2003-04-02 (Corporate Finance)
NEP-FMK-2003-04-02 (Financial Markets)

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