A behavioral model of bubbles and crashes

Kaizoji, Taisei ([e-mail]) (2010): A behavioral model of bubbles and crashes.

Abstract

The aim of this paper is to propose a new model of bubbles and crashes to elucidate a mechanism of bubbles and subsequent crashes. We consider an asset market in which the risky assets into two classes, the risky asset, and the risk-free asset are traded. Investors are divided into two groups of investors who have the different rationality on decision-making respectively. One is arbitragers who maximize their expected utility of their wealth in the next period following their rational assessment of the fundamental values of risky assets. Another is noise traders who maximize their random utility of binary choice: buying the bubble asset and holding the risk-free asst. The noise trader’s behavior is modeled in a framework of the theory of discrete choice with social interaction (Brock and Durlauf (1999, 2001)), which can be considered as a model of Keynse’s beauty contest metaphor. We demonstrate that (i) if noise-traders’ conformity effect (the extent that each noise-trader is influenced by the decisions of other noise-traders) is weak, then the market price converges to the fundamental price, so that the efficient market hypothesis holds, but that (ii) if noise-traders’ conformity effect is strong, then noise-traders’ herd behavior gives cause to a bubble, and their positive-feedback trading prolongs bubble, but a bubble is necessarily ended up with a crash. Furthermore, we describe that cycles of bubbles and crashes are repeated.

• Item Type: MPRA Paper
• Language: English
• Keywords: bubbles, crashes, arbitragers, noise traders, positive-feedback trading, efficient market hypothesis, and Keynesian beauty contest metaphor
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; C - Mathematical and Quantitative Methods > C7 - Game Theory and Bargaining Theory > C73 - Stochastic and Dynamic Games ; Evolutionary Games ; Repeated Games; G - Financial Economics > G0 - General > G01 - Financial Crises

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