An Adaptive Model on Asset Pricing and Wealth Dynamics with Heterogeneous Trading Strategies

Carl Chiarella · Xue-Zhong 'Tony' He

34 citations0/0 files storedRePEc: Research Papers in Economics

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Financial Markets and Investment Strategies Economic theories and models Complex Systems and Time Series Analysis

Abstract

ABSTRACT. This paper develops an adaptive model of asset price and wealth dy-namics in a nancial market with heterogeneous agents and examines the protability of momentum and contrarian trading strategies. In order to characterize asset prices, wealth dynamics and rational adaptiveness arising from the interaction of heteroge-neous agents with CRRA utility, an adaptive discrete time equilibrium model in terms of return and wealth proportions (among heterogeneous representative agents) is es-tablished. Taking trend followers and contrarians as the main heterogeneous agents in the model, the protability of momentum and contrarian trading strategies is an-alyzed. Our results show the capability of the model to characterize some of the existing evidence on many of the anomalies observed in nancial markets, includ-ing the protability of momentum trading strategies over short time intervals and of contrarian trading strategies over long time intervals, rational adaptiveness of agents, overcondence and underreaction, overreaction and herd behavior, excess volatility, and volatility clustering.

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References

1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1993Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency 1976The arbitrage theory of capital asset pricing 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1973An Intertemporal Capital Asset Pricing Model 1994Contrarian Investment, Extrapolation, and Risk n.d.A model of investor sentiment /1999A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets

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