Power-law behaviour, heterogeneity, and trend chasing

He, Xue Zhong; Li, Youwei

Abstract

Long-range dependence in volatility is one of the most prominent examples in financial market research involving universal power laws. Its characterization has recently spurred attempts to provide some explanations of the underlying mechanism. This paper contributes to this recent line of research by analyzing a simple market fraction asset pricing model with two types of traders – fundamentalists who trade on the price deviation from estimated fundamental value and trend followers whose conditional mean and variance of the trend are updated through a geometric learning process. Our analysis shows that agent heterogeneity, risk-adjusted trend chasing through the geometric learning process, and the interplay of noisy fundamental and demand processes and the underlying deterministic dynamics can be the source of power-law distributed fluctuations. In particular, the noisy demand plays an important role in the generation of insignificant autocorrelations (ACs) on returns, while the significant decaying AC patterns of the absolute returns and squared returns are more influenced by the noisy fundamental process. A statistical analysis based on Monte Carlo simulations is conducted to characterize the decay rate. Realistic estimates of the power-law decay indices and the (FI)GARCH parameters are presented.

Citation

He, X. Z., & Li, Y. (2007). Power-law behaviour, heterogeneity, and trend chasing. Journal of Economic Dynamics and Control, 31(10), 3396-3426. https://doi.org/10.1016/j.jedc.2006.11.008

• Journal Article Type: Article
• Acceptance Date: Nov 20, 2006
• Online Publication Date: Feb 6, 2007
• Publication Date: 2007-10
• Deposit Date: Mar 19, 2019
• Publicly Available Date: Aug 11, 2020
• Journal: Journal of Economic Dynamics and Control
• Print ISSN: 0165-1889
• Publisher: Elsevier
• Peer Reviewed: Peer Reviewed
• Volume: 31
• Issue: 10
• Pages: 3396-3426
• DOI: https://doi.org/10.1016/j.jedc.2006.11.008
• Keywords: Asset pricing; Fundamentalists and trend followers; Market fraction; Stability; Learning; Power law
• Public URL: https://hull-repository.worktribe.com/output/1113575
• Publisher URL: https://www.sciencedirect.com/science/article/pii/S0165188906002247?via%3Dihub
• Related Public URLs: http://hdl.handle.net/10453/5111