Trend followers, contrarians and fundamentalists: Explaining the dynamics of financial markets

This paper intends to contribute to the theoretical literature on the determinants of exchange rate fluctuations. We build an agent-based model, based on behavioral assumptions inspired by the literature on behavioral finance and by empirical surveys about the behavior of foreign exchange professionals. In our artificial economy with two countries, traders can speculate on both exchange and interest rates, and allocate their wealth across heterogeneous assets. Fundamentalists use both fundamental and technical analysis, while chartists only employ the latter, and are either trend followers or trend contrarians. In our model, trend contrarians and cash in mechanisms provide the sufficient stability conditions, and allow explaining and replicating most stylized facts of foreign exchange markets, namely (i) the excess volatility of the exchange rate with respect to its fundamentals, (ii) booms, busts and precarious equilibria, (iii) clusters of volatility, (iv) long memory and (v) fat tails.

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Bet against the trend and cash in profits: An agent-based model of endogenous fluctuations of exchange rates

Ramos

Bassi

Lang

2023

J Evol Econ

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Disposition effect and its outcome on endogenous price fluctuations

Cafferata,

Patacca,

Tramontana

2024

Decisions Econ Finan

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We have developed a financial market model that incorporates the Disposition Effect, which refers to traders’ tendency to avoid realizing losses. Specifically, our model replicates several stylized facts commonly observed in financial markets, such as fat tails and volatility clustering. These market characteristics can be attributed to the Disposition Effect, especially when the trading behavior of agents aligns with the findings of Ben-David and Hirshleifer (Rev Financ Stud 25(8):2485–2532, 2012). To demonstrate this, we examine two versions of the model: one where a class of agents exhibits a high degree of Disposition Effect and another where traders are not influenced by it. By comparing the simulated time series generated by both versions, we find that the one with agents affected by the Disposition Effect better replicates the features observed in real financial markets. This holds true for both the deterministic and stochastic versions of the model.

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Market Structure and Instability Artifacts in Heterogeneous Agent Models: Lessons from Implicit Discretizations of Stiff Equations

Baumann

Baumann²,

Grüne

et al. 2022

Comput Econ

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We consider a standard heterogeneous agent model (HAM) that is widely used to analyze price developments in financial markets. The model is linear in log-prices and, in its basic setting, populated by fundamentalists and chartists. As the number of fundamentalists increases and exceeds a specific threshold, oscillations occur whose amplitude might even grow exponentially over time. From an economic perspective to adequately interpret such instability results it is indispensable to ensure that the characteristics and specific building blocks of the HAM are not at odds with the underlying structure of financial markets, in particular the specific trading rules. We expect that in markets with (almost) only fundamentalist traders prices might in the most extreme case oscillate, but never explode. In addition, if limit orders are available, prices should converge monotonically. Finally, if price bubbles occur in financial markets with fundamentalist traders, they should only result from the interactions between fundamentalists and the other traders, e.g., chartists, but not from fundamentalists’ decisions alone. From a mathematical perspective we show that the instability result common to the standard approach can be related to a “hidden” explicit discretization of a stiff ordinary differential equation contained in the model. Replacing this explicit discretization by an implicit one improves the model as it removes this artifact, bringing the model’s prediction in line with standard theory. The refined model still allows for price overshoots, bubbles, and crashes. However, in the implicit model these instabilities are caused by chartists and not by an unintended artifact.

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Trend followers, contrarians and fundamentalists: Explaining the dynamics of financial markets

Cited by 12 publications

References 51 publications

Bet against the trend and cash in profits: An agent-based model of endogenous fluctuations of exchange rates

Bet against the trend and cash in profits: An agent-based model of endogenous fluctuations of exchange rates

Disposition effect and its outcome on endogenous price fluctuations

Market Structure and Instability Artifacts in Heterogeneous Agent Models: Lessons from Implicit Discretizations of Stiff Equations

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