Bubblesandcrashes:Gradientdynamicsinfinancial markets

Daniel Friedman and Ralph Abraham

Santa Cruz Department of Economics, Working Paper Series from Department of Economics, UC Santa Cruz

Abstract: Fund managers respond to the payoff gradient by continuously adjusting leverage in our analytic and simulation models. The base model has a stable equilibrium with classic properties. However, bubbles and crashes occur in extended models incorporating an endogenous market risk premium based on investors' historical losses and constant-gain learning. When losses have been small for a long time, asset prices inflate as fund managers increase leverage. Then slight losses can trigger a crash, as a widening risk premium accelerates deleveraging and asset price declines.

Keywords: Bubbles; Escape dynamics; Time varying risk premium; Constant-gain learning; Agent-based models (search for similar items in EconPapers)
Date: 2008-10-22
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Citations: View citations in EconPapers (1)

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