A model of adaptive, market behavior generating positive returns, volatility and system risk

TL;DR

This paper presents an agent-based model of speculative trading where adaptive behavior leads to persistent price bubbles and increasing systemic risk, highlighting mechanisms behind market volatility and crashes.

Contribution

It introduces a simple adaptive trading model that demonstrates how endogenous agent behavior can generate bubbles and systemic risk without singularities.

Findings

Agents create persistent price bubbles.

Price dynamics show increasing systemic risk.

Market crashes are linked to growing aggregated risk.

Abstract

We describe a simple model for speculative trading based on adaptive behavior of economic agents.The adaptive behavior is expressed through a feedback mechanism for changing agents' stock-to-bond ratios, depending on the past performance of their portfolios.The stock price is set according to the demand-supply for the asset derived from the agents' target risk levels. Using the methodology of agent-based modeling we show that agents, acting endogenously and adaptively, create a persistent price bubble. The price dynamics generated by the trading process does not reveal any singularities, however the process is accompanied by growing aggregated risk that indicates increasing likelihood of a crash.