Super-Exponential Endogenous Bubbles in an Equilibrium Model of Fundamentalist and Chartist Traders
44 Pages Posted: 8 Feb 2015 Last revised: 10 Mar 2015
Date Written: February 3, 2015
We introduce a model of super-exponential financial bubbles with two assets (risky and risk-free), in which fundamentalist and chartist traders co-exist. Fundamentalists form expectations on the return and risk of a risky asset and maximize their constant relative risk aversion expected utility with respect to their allocation on the risky asset versus the risk-free asset. Chartists are subjected to social imitation and follow momentum trading. Allowing for random time-varying herding propensity, we are able to reproduce several well-known stylized facts of financial markets such as a fat-tail distribution of returns and volatility clustering. In particular, we observe transient faster-than-exponential bubble growth with approximate log-periodic behavior and give analytical arguments why this follows from our framework. The model accounts well for the behavior of traders and for the price dynamics that developed during the dotcom bubble in 1995-2000. Momentum strategies are shown to be transiently profitable, supporting these strategies as enhancing herding behavior.
Keywords: financial bubbles, faster-than-exponential growth, social imitation, momentum trading, chartists dotcom bubble
JEL Classification: C73, G01, G17
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