A dynamical model of market under- and overreaction

Jorge R. Sobehart and Ricardo Farengo

Journal of Risk

Abstract: ABSTRACT In this article we introduce a dynamical model of securities prices based on a particular notion of “irrational exuberance” and “market fear” generated by the under- or overreaction of market participants. The addition of a small amount of irrational behavior (behavioral noise) allows us to reproduce realistic distribution of price returns that would be absent in a perfectly rational world. Our model of asset dynamics is based on cognitive biases of market participants and their reaction to price momentum. The resulting price dynamics yields fat-tailed distributions of returns. When we apply our model to the pricing of option contracts we obtain implied volatility skews and smiles generated by the irrational behavior of market participants.

References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.risk.net/journal-risk/2161116/dynamica ... der-and-overreaction (text/html)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:rsk:journ4:2161116

Access Statistics for this article

More articles in Journal of Risk from Journal of Risk
Bibliographic data for series maintained by Thomas Paine ().