Cross-section instability in financial markets: impatience, extrapolation, and switching

This paper presents a stylized model of interaction among boundedly rational heterogeneous agents in a multi-asset financial market to examine how agents’ impatience, extrapolation, and switching behaviors can affect cross-section market stability. Besides extrapolation and performance based switchi...

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Bibliographic Details
Published in:Decisions in economics and finance 2021-12, Vol.44 (2), p.727-754
Main Authors: Dieci, Roberto, He, Xue-Zhong
Format: Article
Language:English
Subjects:
Agents
Assets
Cross-sections
Econometrics
Economic Theory/Quantitative Economics/Mathematical Methods
Economics
Economics and Finance
Extrapolation
Finance
Financial market
Management
Operations Research/Decision Theory
Public Finance
Stability analysis
Switching
Trading
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Summary:This paper presents a stylized model of interaction among boundedly rational heterogeneous agents in a multi-asset financial market to examine how agents’ impatience, extrapolation, and switching behaviors can affect cross-section market stability. Besides extrapolation and performance based switching between fundamental and extrapolative trading documented in single asset market, we show that a high degree of ‘impatience’ of agents who are ready to switch to more profitable trading strategy in the short run provides a further cross-section destabilizing mechanism. Though the ‘fundamental’ steady-state values, which reflect the standard present-value of the dividends, represent an unbiased equilibrium market outcome in the long run (to a certain extent), the price deviation from the fundamental price in one asset can spill-over to other assets, resulting in cross-section instability. Based on a (Neimark–Sacker) bifurcation analysis, we provide explicit conditions on how agents’ impatience, extrapolation, and switching can destabilize the market and result in a variety of short and long-run patterns for the cross-section asset price dynamics.
ISSN:1593-8883
1129-6569
DOI:10.1007/s10203-021-00348-5