Market Dynamics When Agents Anticipate Correlation Breakdown

Abstract

The aim of this paper is to analyse the effect introduced in the dynamics of a financial market when agents anticipate the occurrence of a correlation breakdown. What emerges is that correlation breakdowns can act both as a consequence and as a triggering factor in the emergence of financial crises rational bubbles. We propose a market with two kinds of agents: speculators and rational investors. Rational agents use excess demand information to estimate the variance-covariance structure of assets returns, and their investment decisions are represented as a Markowitz optimal portfolio allocation. Speculators are uninformed agents and form their expectations by imitative behavior, depending on market excess demand. Several market equilibria result, depending on the prevalence of one of the two types of agents. Differing from previous results in the literature on the interaction between market dynamics and speculative behavior, rational agents can generate financial crises, even without the speculator contribution.

Does Expectation of Correlation Breakdown in Financial Market Fulfill Itself?

“…The model of Falbo and Grassi [15] generates returns of the stock price distributed in a way consistent with the variance function in (4). However, with respect to the correlation, that paper did not say anything conclusive since the model was missing an equation linking the low-risk asset returns to the excess demand .…”

“…Moving from the settings in Falbo and Grassi [15] that we partially recover here to introduce the notation and to make this paper minimally self-contained, we consider a market with two types of agents, rational investors and speculators. These agents interact in a discrete time framework by trading two kinds of assets, a stock and a consol bond , with different risk levels and different expected returns, and , respectively.…”

“…The parameter in the variance equation 4can be either positive or negative; assuming that is positive amounts to estimating (on the side of the rational agents) that V → +∞ as → ±∞, whereas V → 0 as → ±∞ for negative . This is a slight modification of the original model of Falbo and Grassi [15] which generalizes possible empirical applications.…”

“…In their empirical application Falbo and Grassi [15] develop a proxy of the excess demand of a stock index. We recover the same equations, since that variable is also needed here to model the returns of low-risky assets.…”

“…In this work we analyze the model of Falbo and Grassi [15] where the price dynamics of two assets (a high-risk and a low-risk ones) is subject to a time varying correlation. In particular, the authors consider the case where rational investors use expectation of excess demand to forecast the correlation between the assets to compose their investment portfolio.…”