Prospect Agents and the Feedback Effect on Price Fluctuations

TL;DR

This paper models market participants as prospect trading agents to analyze how their behaviors influence asset price fluctuations and explain observed volatility patterns.

Contribution

It introduces a microeconomic model linking prospect agent behavior with price dynamics and the feedback effect, explaining volatility skew and smile.

Findings

Demonstrates the feedback effect impacts price fluctuations

Explains the implied volatility skew and smile

Links trading behavior to market volatility patterns

Abstract

A microeconomic approach is proposed to derive the fluctuations of risky asset price, where the market participants are modeled as prospect trading agents. As asset price is generated by the temporary equilibrium between demand and supply, the agents' trading behaviors can affect the price process in turn, which is called the feedback effect. The prospect agents make actions based on their reactions to gains and losses, and as a consequence of the feedback effect, a relationship between the agents' trading behavior and the price fluctuations is constructed, which explains the implied volatility skew and smile observed in actual market.