Cross-section instability in financial markets: impatience, extrapolation, and switching

Roberto Dieci () and Xuezhong (Tony) He ()
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Roberto Dieci: University of Bologna

Decisions in Economics and Finance, 2021, vol. 44, issue 2, No 11, 727-754

Abstract: Abstract This paper presents a stylized model of interaction among boundedly rational heterogeneous agents in a multi-asset financial market to examine how agents’ impatience, extrapolation, and switching behaviors can affect cross-section market stability. Besides extrapolation and performance based switching between fundamental and extrapolative trading documented in single asset market, we show that a high degree of ‘impatience’ of agents who are ready to switch to more profitable trading strategy in the short run provides a further cross-section destabilizing mechanism. Though the ‘fundamental’ steady-state values, which reflect the standard present-value of the dividends, represent an unbiased equilibrium market outcome in the long run (to a certain extent), the price deviation from the fundamental price in one asset can spill-over to other assets, resulting in cross-section instability. Based on a (Neimark–Sacker) bifurcation analysis, we provide explicit conditions on how agents’ impatience, extrapolation, and switching can destabilize the market and result in a variety of short and long-run patterns for the cross-section asset price dynamics.

Keywords: Heterogeneous beliefs; Asset pricing; Portfolio choice; Strategy switching; Bifurcation analysis (search for similar items in EconPapers)
JEL-codes: C61 D84 G11 G12 (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (2)

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DOI: 10.1007/s10203-021-00348-5

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