The cavity method for minority games between arbitrageurs on financial markets

TL;DR

This paper applies the cavity method from statistical physics to analyze the dynamics of minority games in financial markets, revealing how noise and nonlinear price functions influence arbitrage and market stability.

Contribution

It introduces a cavity method-based approach to model transient and stationary market dynamics, incorporating nonlinear responses and noise effects in minority games.

Findings

Noise reduces arbitrage opportunities under certain conditions

Market response captures realistic agent preferences without fixation

Method indicates potential for critical volatility and regime shifts

Abstract

We use the cavity method from statistical physics for analyzing the transient and stationary dynamics of a minority game that is played by agents performing market arbitrage. On the level of linear response the method allows to include the reaction of the market to individual actions of the agents as well as the reaction of the agents to individual information items of the market. This way we derive a self-consistent solution to the minority game. In particular we analyze the impact of general nonlinear price functions on the amount of arbitrage if noise from external fluctuations is present. We identify the conditions under which arbitrage gets reduced due to the presence of noise. When the cavity method is extended to time dependent response of the market price to previous actions of the agents, the individual contributions of noise can be pursued over different time scales in the transient dynamics until a stationary state is reached and when the stationary state is reached. The contributions are from external fluctuations in price and information and from noise due to the choice of strategies. The dynamics explains the time evolution of scores of the agents' strategies: it changes from initially a random walk to non-Markovian dynamics and bounded excursions on an intermediate time scale to effectively random switching in the choice between strategies on long time scales. In contrast to the Curie-Weiss level of a mean-field approach, the market response included by the cavity method captures the realistic feature that the agents can have a preference for a certain choice of strategies without getting stuck to a single choice. The breakdown of the method in the phase transition region indicates possible market mechanisms leading to critical volatility and a possible regime shift.