Microfounding GARCH Models and Beyond: A Kyle-inspired Model with Adaptive Agents

20 Pages Posted: 23 Jun 2022

See all articles by Michele Vodret

Michele Vodret

Ecole Polytechnique, Palaiseau

Iacopo Mastromatteo

Capital Fund Management

Bence Toth

Capital Fund Management

Michael Benzaquen

Ecole Polytechnique, Palaiseau; Capital Fund Management

Date Written: June 14, 2022

Abstract

We relax the strong rationality assumption for the agents in the paradigmatic Kyle model of price formation, thereby reconciling the framework of asymmetrically informed traders with the Adaptive Market Hypothesis, where agents use inductive rather than deductive reasoning. Building on these ideas, we propose a stylised model able to account parsimoniously for a rich phenomenology, ranging from excess volatility to volatility clustering. While characterising the excess-volatility dynamics, we provide a microfoundation for GARCH models. Volatility clustering is shown to be related to the self-excited dynamics induced by traders' behaviour, and does not rely on clustered fundamental innovations. Finally, we propose an extension to account for the fragile dynamics exhibited by real markets during flash crashes.

Suggested Citation

Vodret, Michele and Mastromatteo, Iacopo and Toth, Bence and Benzaquen, Michael and Benzaquen, Michael, Microfounding GARCH Models and Beyond: A Kyle-inspired Model with Adaptive Agents (June 14, 2022). Available at SSRN: https://ssrn.com/abstract=4136389 or http://dx.doi.org/10.2139/ssrn.4136389

Michele Vodret

Ecole Polytechnique, Palaiseau ( email )

Route de Saclay
Palaiseau, 91128
France

Iacopo Mastromatteo

Capital Fund Management ( email )

France

Bence Toth

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
France

Michael Benzaquen (Contact Author)

Ecole Polytechnique, Palaiseau ( email )

Route de Saclay
Palaiseau, 91128
France

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
France

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