Power-law behaviour, heterogeneity, and trend chasing

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jedc.2006.11.008 Byline: Xue-Zhong He (a), Youwei Li (b) Abstract: Long-range dependence in volatility is one of the most prominent examples in financial market research involving universal power laws. Its characterization has recently spurred attempts to provide some explanations of the underlying mechanism. This paper contributes to this recent line of research by analyzing a simple market fraction asset pricing model with two types of traders - fundamentalists who trade on the price deviation from estimated fundamental value and trend followers whose conditional mean and variance of the trend are updated through a geometric learning process. Our analysis shows that agent heterogeneity, risk-adjusted trend chasing through the geometric learning process, and the interplay of noisy fundamental and demand processes and the underlying deterministic dynamics can be the source of power-law distributed fluctuations. In particular, the noisy demand plays an important role in the generation of insignificant autocorrelations (ACs) on returns, while the significant decaying AC patterns of the absolute returns and squared returns are more influenced by the noisy fundamental process. A statistical analysis based on Monte Carlo simulations is conducted to characterize the decay rate. Realistic estimates of the power-law decay indices and the (FI)GARCH parameters are presented. Author Affiliation: (a) School of Finance and Economics, University of Technology, Sydney, P.O. Box 123, Broadway, NSW 2007, Australia (b) School of Management and Economics, Queen's University Belfast, 25 University Square, Belfast, BT7 1NN, UK Article History: Received 10 February 2005; Accepted 20 November 2006