Cross-section Instability in Financial Markets: Impatience, Extrapolation, and Switching

Decisions in Economics and Finance

26 Pages Posted: 20 Jul 2021

See all articles by Roberto Dieci

Roberto Dieci

Department of Mathematics, University of Bologna

Xuezhong He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School; Financial Research Network (FIRN)

Date Written: July 18, 2021

Abstract

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 behaviours 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 pro table 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.

Keywords: heterogeneous beliefs, asset pricing, portfolio choice, strategy switching, bifurcation analysis

JEL Classification: C61, D84, G11, G12

Suggested Citation

Dieci, Roberto and He, Xue-Zhong 'Tony', Cross-section Instability in Financial Markets: Impatience, Extrapolation, and Switching (July 18, 2021). Decisions in Economics and Finance, Available at SSRN: https://ssrn.com/abstract=3888913

Roberto Dieci

Department of Mathematics, University of Bologna ( email )

Piazza di Porta San Donato, 5
Bologna, I-40126
Italy

HOME PAGE: http://www.unibo.it/Faculty/default.aspx?UPN=roberto.dieci%40unibo.it

Xue-Zhong 'Tony' He (Contact Author)

University of Technology Sydney (UTS) - Finance Discipline Group, Business School ( email )

Haymarket
Sydney, NSW 2007
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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