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Bubbles and crashes: Gradient dynamics in financial markets

  • Friedman, Daniel
  • Abraham, Ralph

Fund managers respond to the payoff gradient by continuously adjusting leverage in our analytic and simulation models. The base model has a stable equilibrium with classic properties. However, bubbles and crashes occur in extended models incorporating an endogenous market risk premium based on investors' historical losses and constant-gain learning. When losses have been small for a long time, asset prices inflate as fund managers increase leverage. Then slight losses can trigger a crash, as a widening risk premium accelerates deleveraging and asset price declines.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 33 (2009)
Issue (Month): 4 (April)
Pages: 922-937

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Handle: RePEc:eee:dyncon:v:33:y:2009:i:4:p:922-937
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