Self Referential Behaviour, Overreaction and Conventions in Financial Markets

16 Pages Posted: 18 Jun 2003

See all articles by Matthieu Wyart

Matthieu Wyart

Centre d'Etudes de Saclay (CEA) - Service de Physique de l'Etat Condense (SPEC)

Jean-Philippe Bouchaud

Capital Fund Management

Date Written: March 28, 2003

Abstract

We study a generic model for self-referential behaviour in financial markets, where agents attempt to use some (possibly fictitious) causal correlations between a certain quantitative information and the price itself. This correlation is estimated using the past history itself, and is used by a fraction of agents to devise active trading strategies. The impact of these strategies on the price modify the observed correlations. A potentially unstable feedback loop appears and leads to a 'phase transition' beyond which non trivial correlations spontaneously set in, or are anomalously amplified. For large enough feedback, the market switches between two long lived states, that we call conventions. This mechanism leads to overreaction and excess volatility, which may be considerable in the convention phase. A particularly interesting case is when the source of information is the price itself. The two conventions then correspond then to either a trend following regime or to a contrarian (mean reverting) regime. We provide some empirical evidence for the existence of these conventions in real markets, that can last several decades.

Keywords: Self referential behaviour, overreaction, conventions, excess volatility, excess correlations, regime shift

JEL Classification: C71, C73, D83, G14

Suggested Citation

Wyart, Matthieu and Bouchaud, Jean-Philippe, Self Referential Behaviour, Overreaction and Conventions in Financial Markets (March 28, 2003). Available at SSRN: https://ssrn.com/abstract=391861 or http://dx.doi.org/10.2139/ssrn.391861

Matthieu Wyart

Centre d'Etudes de Saclay (CEA) - Service de Physique de l'Etat Condense (SPEC) ( email )

Orme des Meurisiers
91191 Gif-sur-Yvette cedex
France
+33 1 69 08 72 45 (Phone)
+33 1 69 08 87 86 (Fax)

Jean-Philippe Bouchaud (Contact Author)

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
France
+33 1 49 49 59 20 (Phone)

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