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Price Dynamics in a Market with Heterogeneous Investment Horizons and Boundedly Rational Traders

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    Abstract

    This paper studies the effects of multiple investment horizons and investors' bounded rationality on the price dynamics. We consider a pure exchange economy with one risky asset, populated with agents maximizing CRRA-type expected utility of wealth over discrete investment periods. An investor's demand for the risky asset may depend on the historical returns, so that our model encompasses a wide range of behaviorist patterns. The necessary conditions, under which the risky return can be a stationary iid process, are established. The compatibility of these conditions with different types of demand functions in the heterogeneous agents' framework are explored. We find that conditional volatility of returns cannot be constant in many generic situations, especially if agents with different investment horizons operate on the market. In the latter case the return process can display conditional heteroscedasticity, even if all investors are so-called "fundamentalists" and their demand for the risky asset is subject to exogenous iid shocks. We show that the heterogeneity of investment horizons can be a possible explanation of different stylized patterns in stock returns, in particular, mean-reversion and volatility clustering.

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    File URL: ftp://mse.univ-paris1.fr/pub/mse/CES2010/10048.pdf
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    Bibliographic Info

    Paper provided by Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne in its series Documents de travail du Centre d'Economie de la Sorbonne with number 10048.

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    Length: 43 pages
    Date of creation: Apr 2010
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    Handle: RePEc:mse:cesdoc:10048

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    Keywords: Asset pricing; heterogeneous agents; multiple investment scales; volatility clustering.;

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    1. R. Cont, 2001. "Empirical properties of asset returns: stylized facts and statistical issues," Quantitative Finance, Taylor & Francis Journals, vol. 1(2), pages 223-236.
    2. C. Chiarella & X-Z. He, 2001. "Asset price and wealth dynamics under heterogeneous expectations," Quantitative Finance, Taylor & Francis Journals, vol. 1(5), pages 509-526.
    3. Weinbaum, David, 2009. "Investor heterogeneity, asset pricing and volatility dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 33(7), pages 1379-1397, July.
    4. Chan, K C, 1988. "On the Contrarian Investment Strategy," The Journal of Business, University of Chicago Press, vol. 61(2), pages 147-63, April.
    5. Andersen, Torben G, 1996. " Return Volatility and Trading Volume: An Information Flow Interpretation of Stochastic Volatility," Journal of Finance, American Finance Association, vol. 51(1), pages 169-204, March.
    6. Mikhail Anufriev, 2005. "Wealth-Driven Competition in a Speculative Financial Market: Examples with Maximizing Agents," LEM Papers Series 2005/27, Laboratory of Economics and Management (LEM), Sant'Anna School of Advanced Studies, Pisa, Italy.
    7. Boudoukh, Jacob & Richardson, Matthew P & Whitelaw, Robert F, 1994. "A Tale of Three Schools: Insights on Autocorrelations of Short-Horizon Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 7(3), pages 539-73.
    8. Anufriev, Mikhail & Bottazzi, Giulio & Pancotto, Francesca, 2006. "Equilibria, stability and asymptotic dominance in a speculative market with heterogeneous traders," Journal of Economic Dynamics and Control, Elsevier, vol. 30(9-10), pages 1787-1835.
    9. Vanden, Joel M., 2005. "Equilibrium analysis of volatility clustering," Journal of Empirical Finance, Elsevier, vol. 12(3), pages 374-417, June.
    10. repec:att:wimass:9621 is not listed on IDEAS
    11. Brock, William A. & Hommes, Cars H., 1998. "Heterogeneous beliefs and routes to chaos in a simple asset pricing model," Journal of Economic Dynamics and Control, Elsevier, vol. 22(8-9), pages 1235-1274, August.
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    Cited by:
    1. Yi Xue & Ramazan Gencay, 2009. "Trading Frequency and Volatility Clustering," Working Paper Series 31_09, The Rimini Centre for Economic Analysis, revised Jan 2009.

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