Rational Speculators, Contrarians and Excess Volatility

Lof, Matthijs (2012): Rational Speculators, Contrarians and Excess Volatility.

Abstract

The VAR approach for testing present value models is applied to a heterogeneous-agent asset pricing model, using historical observations of the S&P500 index. Besides fundamentalists, who value assets according to expected dividends, the model features rational and contrarian speculators. Agents choose their strategy based on evolutionary considerations. Supplementing the standard present value model with speculative agents dramatically improves the model’s ability to replicate observed market dynamics. In particular the existence of contrarians can explain some of the most volatile episodes including the 1990s bubble, suggesting this was not a rational bubble.

• Item Type: MPRA Paper
• Language: English
• Keywords: asset pricing, heterogeneous agents, VAR approach
• Subjects: C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C51 - Model Construction and Estimation; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D84 - Expectations ; Speculations; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions

References

Alfarano, S., T. Lux, and F. Wagner: 2005, ‘Estimation of agent-based models: the case of an asymmetric herding model’. Computational Economics 26(1), 19–49.

Ang, A. and G. Bekaert: 2002, ‘International asset allocation with regime shifts’. Review of Financial studies 15(4), 1137–1187.

Anufriev, M. and G. Bottazzi: 2012, ‘Asset Pricing with Heterogeneous Investment Horizons’. Studies in Nonlinear Dynamics & Econometrics 16(4).

Arrow, K. J.: 1986, ‘Rationality of self and others in an economic system’. Journal of Business 59(4), S385–S399.

Barberis, N., A. Shleifer, and R. Vishny: 1998, ‘A model of investor sentiment’. Journal of financial economics 49(3), 307–343.

Barberis, N. and R. Thaler: 2003, ‘A survey of behavioral finance’. Handbook of the Economics of Finance 1, 1053–1128.

Baur, D. and K. Glover: 2011, ‘A Behavioural Finance Approach with Fundamentalists and Chartists in the Gold Market’. University of Technology Sydney Working Paper.

Blanchard, O. and M. Watson: 1982, ‘Bubbles, Rational Expectations and Financial Markets’. NBER Working Paper (945).

Bloomfield, R. and J. Hales: 2002, ‘Predicting the next step of a random walk: experimental evidence of regime-shifting beliefs’. Journal of Financial Economics 65(3), 397–414.

Bloomfield, R., M. O Hara, and G. Saar: 2009, ‘How noise trading affects markets: An experimental analysis’. Review of Financial Studies 22(6), 2275–2302.

Boswijk, H. P., C. H. Hommes, and S. Manzan: 2007, ‘Behavioral heterogeneity in stock prices’. Journal of Economic Dynamics and Control 31(6), 1938–1970.

Bradley, D., B. Jordan, and J. Ritter: 2008, ‘Analyst behavior following IPOs: the ’bubble period’ evidence’. Review of Financial Studies 21(1), 101–133.

Branch, W. and G. Evans: 2010, ‘Asset return dynamics and learning’. Review of Financial Studies 23(4), 1651–1680.

Branch, W. and G. Evans: 2011, ‘Learning about risk and return: A simple model of bubbles and crashes’. American Economic Journal: Macroeconomics 3(3), 159–191.

Brock, W. A. and C. H. Hommes: 1997, ‘A Rational Route to Randomness’. Econometrica 65(5), 1059– 1096.

Brock,W. A. and C. H. Hommes: 1998, ‘Heterogeneous beliefs and routes to chaos in a simple asset pricing model’. Journal of Economic Dynamics and Control 22(8-9), 1235–1274.

Campbell, J. and R. Shiller: 1987, ‘Cointegration and Tests of Present Value Models’. Journal of Political Economy 95(5), 1062–1088.

Campbell, J. Y. and R. J. Shiller: 1988, ‘The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors’. Review of Financial Studies 1(3), 195–228.

Cochrane, J. H.: 2011, ‘Presidential Address: Discount Rates’. The Journal of Finance 66(4), 1047–1108.

Cornea, A., C. Hommes, and D. Massaro: 2012, ‘Behavioral Heterogeneity in US Inflation Dynamics’. CeNDEF Working paper.

Davidson, R. and J. MacKinnon: 1981, ‘Several tests for model specification in the presence of alternative hypotheses’. Econometrica 49(3), 781–793.

De Long, J., A. Shleifer, L. Summers, and R. Waldmann: 1990a, ‘Noise Trader Risk in Financial Markets’. Journal of Political Economy 98(4), 703–738.

De Long, J., A. Shleifer, L. Summers, and R. Waldmann: 1990b, ‘Positive Feedback Investment Strategies and Destabilizing Rational Speculation’. The Journal of Finance pp. 379–395.

Dechow, P. and R. Sloan: 1997, ‘Returns to contrarian investment strategies: Tests of naive expectations hypotheses’. Journal of Financial Economics 43(1), 3–27.

Eichholtz, P., R. Huisman, and R. Zwinkels: 2012, ‘Fundamentals or Trends? A Long-Term Perspective on House Prices’.

Ellen, S. t. and R. C. Zwinkels: 2010, ‘Oil price dynamics: A behavioral finance approach with heterogeneous agents’. Energy Economics 32(6), 1427–1434.

Engsted, T., T. Pedersen, and C. Tanggaard: 2012, ‘The Log-Linear Return Approximation, Bubbles, and Predictability’. Journal of Financial and Quantitative Analysis 47(3), 643–665.

Fama, E. F. and K. R. French: 2001, ‘Disappearing dividends: changing firm characteristics or lower propensity to pay?’. Journal of Financial Economics 60(1), 3–43.

Gilles, C. and S. LeRoy: 1991, ‘Econometric aspects of the variance-bounds tests: A survey’. Review of Financial Studies 4(4), 753–791.

Grinblatt, M. and M. Keloharju: 2000, ‘The investment behavior and performance of various investor types: a study of Finland’s unique data set’. Journal of Financial Economics 55(1), 43–67.

Guidolin, M. and A. Timmermann: 2008, ‘International asset allocation under regime switching, skew, and kurtosis preferences’. Review of Financial Studies 21(2), 889–935.

Gürkaynak, R.: 2008, ‘Econometric Tests of Asset Price Bubbles: Taking Stock’. Journal of Economic Surveys 22(1), 166–186.

Hommes, C., J. Sonnemans, J. Tuinstra, and H. Van de Velden: 2005, ‘Coordination of expectations in asset pricing experiments’. Review of Financial Studies 18(3), 955–980.

Hong, H. and J. Stein: 1999, ‘A unified theory of underreaction, momentum trading, and overreaction in asset markets’. The Journal of Finance 54(6), 2143–2184.

Hong, H., J. Stein, and J. Yu: 2007, ‘Simple forecasts and paradigm shifts’. The Journal of Finance 62(3), 1207–1242.

Jegadeesh, N. and S. Titman: 1995, ‘Overreaction, delayed reaction, and contrarian profits’. Review of Financial Studies 8(4), 973–993.

Kaniel, R., G. Saar, and S. Titman: 2008, ‘Individual investor trading and stock returns’. The Journal of Finance 63(1), 273–310.

Kouwenberg, R. and R. Zwinkels: 2011, ‘Chasing trends in the US housing market’. Erasmus University Rotterdam Working Paper.

Lakonishok, J., A. Shleifer, and R. Vishny: 1994, ‘Contrarian Investment, Extrapolation, and Risk’. The Journal of Finance pp. 1541–1578.

Lof, M.: 2012, ‘Heterogeneity in stock prices: A STAR model with multivariate transition function’. Journal of Economic Dynamics and Control 36(12), 1845 – 1854.

Lof, M.: 2013, ‘Noncausality and Asset Pricing’. Studies in Nonlinear Dynamics and Econometrics 17(2), 211–220.

Lütkepohl, H. and M. Krätzig: 2004, Applied time series econometrics. Cambridge University Press.

Ofek, E. and M. Richardson: 2003, ‘DotCom Mania: The Rise and Fall of Internet Stock Prices’. The Journal of Finance 58(3), 1113–1138.

O’Hara, M.: 2008, ‘Bubbles: Some perspectives (and loose talk) from history’. Review of Financial Studies 21(1), 11–17.

Park, A. and H. Sabourian: 2011, ‘Herding and contrarian behavior in financial markets’. Econometrica 79(4), 973–1026.

Pástor, L. and P. Veronesi: 2006, ‘Was there a Nasdaq bubble in the late 1990s?’. Journal of Financial Economics 81(1), 61–100.

Phillips, P., Y. Wu, and J. Yu: 2011, ‘Explosive Behavior in the 1990s’ NASDAQ: When Did Exuberance Escalate Asset Values?’. International economic review 52(1), 201–226.

Shiller, R. J.: 1981, ‘Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?’. American Economic Review 71(3), 421–36.

Szafarz, A.: 2012, ‘Financial crises in efficient markets: How fundamentalists fuel volatility’. Journal of Banking and Finance 36(1), 105 – 111.

Timmerman, A.: 1994, ‘Can agents learn to rational expectations? Some results on convergence and stability of learning in the UK stock market’. The Economic Journal pp. 777–797.

West, K. D.: 1988, ‘Dividend Innovations and Stock Price Volatility’. Econometrica 56(1), 37–61.