Incentives and Adaptive Expectations in a Financial Market with Heterogenous Agents

Abstract

This paper establishes an agent-based model to describe the dynamic behaviour of the financial market with mutual fund managers and investors under two types of compensation contracts: asset-based fees and performance-based fees, and using two types of adaptive expectation: trend chaser and contrarian. Our results show that both of trading strategies of trend chaser and contrarian destabilise the market. However, trend chasers always trigger significant fluctuations, while contrarian traders bring along the slight up and down oscillations. The types of compensation contracts change the behaviour of contrarian traders, but have no influence to trend chaser. We also find that inertia parameter decrease the stability of market and induce market price to be underestimated. In particular, the heterogenous analysis under different compensation contracts shows that asset maximisers dominate the whole market and produce higher returns, which can be used to explain the current situation in real market that most of mutual funds choose asset-based contract.Moreover, the coexistence of two compensation schemes may amplify market fluctuations and create bubbles.