Beauty Contests and Fat Tails in Financial Markets

Makoto Nirei and Tsutomu Watanabe
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Tsutomu Watanabe: University of Tokyo

No 24, UTokyo Price Project Working Paper Series from University of Tokyo, Graduate School of Economics

Abstract: Using a simultaneous-move herding model of rational traders who infer other traders' private information on the value of an asset by observing their aggre- gate actions, this study seeks to explain the emergence of fat-tailed distributions of transaction volumes and asset returns in financial markets. Without mak- ing any parametric assumptions on private information, we analytically show that traders' aggregate actions follow a power law distribution. We also provide simulation results to show that our model successfully reproduces the empirical distributions of asset returns. We argue that our model is similar to Keynes's beauty contest in the sense that traders, who are assumed to be homogeneous, have an incentive to mimic the average trader, leading to a situation similar to the indeterminacy of equilibrium. In this situation, a trader's buying action causes a stochastic chain-reaction, resulting in power laws for financial fluctuations.

Keywords: Herd behavior; transaction volume; stock return; fat tail; power law (search for similar items in EconPapers)
JEL-codes: G14 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2014-06
New Economics Papers: this item is included in nep-bec and nep-pbe
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Related works:
Working Paper: Beauty Contests and Fat Tails in Financial Markets (2014)
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