Excess covariance and dynamic instability in a multi-asset model

Mikhail Anufriev, Giulio Bottazzi, Matteo Marsili and Paolo Pin

Journal of Economic Dynamics and Control, 2012, vol. 36, issue 8, 1142-1161

Abstract: The presence of excess covariance in financial price returns is an accepted empirical fact: the price dynamics of financial assets tend to be more correlated than their fundamentals would justify. We advance an explanation of this fact based on an intertemporal equilibrium multi-assets model of financial markets with an explicit and endogenous price dynamics. The market is driven by an exogenous stochastic process of dividend yields paid by the assets that we identify as market fundamentals. The model is rather flexible and allows for the coexistence of different trading strategies. The evolution of assets price and traders' wealth is described by a high-dimensional stochastic dynamical system. We identify the equilibria of the model consistent with a baseline assumption of procedural rationality. We show that these equilibria are characterized by excess covariance in prices with respect to the dividend process. Moreover, we show that in equilibrium there is a positive expected marginal profit in choosing more risky portfolios. As a consequence, the evolutionary pressure generates a trend towards more remunerative strategies, which, in turn, increase the variance of prices and the dynamic instability of the system.

Keywords: Excess covariance; Capital asset pricing model; Efficient market hypothesis; Heterogeneous agents; Procedurally consistent equilibrium (search for similar items in EconPapers)
JEL-codes: D81 G11 G12 (search for similar items in EconPapers)
Date: 2012
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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Working Paper: Excess Covariance and Dynamic Instability in a Multi-Asset Model (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:36:y:2012:i:8:p:1142-1161

DOI: 10.1016/j.jedc.2012.03.015

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