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Bubblesandcrashes:Gradientdynamicsinï¬ nancial 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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Paper provided by Department of Economics, UC Santa Cruz in its series Santa Cruz Department of Economics, Working Paper Series with number qt3905j8kq.

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Date of creation: 22 Oct 2008
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Handle: RePEc:cdl:ucscec:qt3905j8kq
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