The Intrinsic Instability of Financial Markets

TL;DR

This paper explains the extreme fluctuations in financial markets as a result of intrinsic feedback mechanisms, modeling asset returns as a multiplicative process that naturally produces power-law distributions and unifies various theories.

Contribution

It introduces a general framework for understanding market volatility through multiplicative random growth, integrating existing models and highlighting the role of feedback in price dynamics.

Findings

Asset returns follow a power-law distribution.

Market fluctuations can be explained by intrinsic feedback mechanisms.

The framework unifies different theoretical approaches.

Abstract

In this paper we explain the wild fluctuations of financial prices from the intrinsic amplifying feedback of speculative supply and demand. Formally, we show that an asset return follows a multiplicative random growth with exogenous input, which is well-known to be a generic power-law generating process, and which could thus easily explain the well-established power-law distribution of returns, and other related variables. Moreover, the theory we develop here is a general framework where competing ideas can be discussed in a unified way. The dominant random walk model, for instance, is easily derived in this framework if we superimpose market clearing (central to neoclassical economics). It corresponds to the case where the feedback in price dynamics is ignored in favor of the external input, namely the random inflow of news from the real economy.