An agent-based early warning indicator for financial market instability

David Vidal-Tomás and Simone Alfarano

Journal of Economic Interaction and Coordination, 2020, vol. 15, issue 1, No 3, 49-87

Abstract: Abstract Inspired by the Bank of America Merrill Lynch global breath rule, we propose an investor sentiment index based on the collective movement of stock prices in a given market. We show that the time evolution of the sentiment index can be reasonably described by the herding model proposed by Kirman in his seminal paper “Ants, rationality and recruitment” (Kirman in Q J Econ 108:137–156, 1993). The correspondence between the index and the model allowed us to easily estimate its parameters. Based on the model and the empirical evolution of the sentiment index, we propose an early warning indicator able to identify optimistic and pessimistic phases of the market. As a result, investors and policy-makers can set different strategies anticipating financial market instability. Investors can reduce the risk of their portfolio while policy-makers can set more efficient policies to avoid the effects of financial instability on the real economy. The validity of our results is supported by means of a robustness analysis showing the application of the early warning indicator in eight different worldwide stock markets.

Keywords: Herding behavior; Kirman model; Financial market (search for similar items in EconPapers)
JEL-codes: C61 D84 G10 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (7)

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Working Paper: An agent based early warning indicator for financial market instability (2018)
Working Paper: An agent based early warning indicator for financial market instability (2018)
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DOI: 10.1007/s11403-019-00272-3

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