Economy – Quantitative Finance – Statistical Finance
Scientific paper
2011-09-22
Economy
Quantitative Finance
Statistical Finance
33 pages + 6 figures
Scientific paper
We introduce a model of financial bubbles with two assets (risky and risk-less), in which rational investors and noise traders co-exist. Rational investors form continuously evolving expectations on the return and risk of a risky asset and maximize their expected utility with respect to their allocation on the risky asset versus the risk-free asset. Noise traders are subjected to social imitation and follow momentum trading. We find the existence of a set of bifurcations controlled by the relative influence of noise traders with respect to rational investors that separate a normal regime of the price dynamics to a phase punctuated by recurrent exponentially explosive bubbles. The transition to a bubble regime is favored by noise traders who are more social, and who use more momentum trading with shorter time horizons. 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.
Kaizoji Taisei
Saichev Alexander
Sornette Didier
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