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Heterogeneous Agents in Finance different heuristics and different representations of problems

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59 pages
Heterogeneous Agents in Finance : different heuristics and different representations of problems Massimo Egidi Luiss University Prepared for The Conference on Quantitative Behavioral Finance, Nice Dec. 8-11, 2010

  • traditional representative

  • ?? simon

  • agents using

  • simon developed

  • rational expectations

  • bounded rationality emerged

  • financial pages


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Heterogeneous Agents in Finance : different
heuristics and different representations of
problems

Massimo Egidi
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PNriceep aDreecd. f8o-r 1T1h, e2 C0o1n0f erence on Quantitative Behavioral Finance,

Heterogeneous Agents in Finance : different heuristics and
different representations of problems

oconimsca dnf ninaeca erw tienssni gnai pmroattn “Eparadigm shift, from a representative, rational agent
approach towards a behavioral, agent-based approach in
which markets are populated with boundedly rational,
heterogeneous agents using rule of thumb strategies. “
(Cars Hommes)

Heterogeneous Agents in Finance : different heuristics and different
representations of problems

 

 

Simon built the idea of bounded rationality on close
ionb lsaerrgvea toirogn aonfi ztahtei obnes.h aDvuiorirn ogf t heem 1p9lo5y0ese as nadn ed armlya nagers
1960s, he took part in numerous collaborations and
rAedsmeainricsht rpartioojen ctosf Cata rtnhee giGer aMdeullaotne, Sacmhooonlg otfh Ienmd uas tsrtiauld y
owfi tdhe cCihsiaorlne sm Hakoiltn,g F uranndceor uMnocdeirgtliaainnit ya ncod nJdouhcnt eFd. jMoiuntthl.y

The aim of the study was to develop mathematical tools
to improve inventory control systems for production
pCloamnnpianngy .a tI ta wpalas nitn otfh itsh ec oPnitttesxbt uorfg th hPel actoen cGrleatses study of
“esmatpiisrfiiccailn gd”a tbae thhaavti oSri, maonnd dtheavte ltohpee tdw hoi so epaprolsyi tneo itdioenass ooff
Rational Expectations (Muth) and Bounded Rationality
emerged.

Heterogeneous Agents in Finance : different heuristics and
different representations of problems

In a perfectly rational EMH world all traders are rational and
it is common knowledge that all traders are rational. In real
financial markets however, traders are different, especially
with respect to their expectations about future prices and
dividends.
A quick glance at the financial pages of newspapers is
sufficient to observe that difference of opinions among
financial analysts is the rule rather than the exception. In
the last decade, a rapidly increasing number of structural
heterogeneous agent models have been introduced in the
finance literature

Heterogeneous Agents in Finance : different heuristics and
different representations of problems

In the traditional approach, simple analytically tractable
bmeoedne ltsh ew itmha ian rceoprrneesre snttoatnievse ,a pnedr fmecattlhye rmataitoicnsa l haags ebnet ehna tvhe e
main tool of analysis.

cThhael lneengw ebs ethhaev tiroaradli,t ihoentael rroegperneeseonutsa taigvee,n trsa taipopnraol aacghe nt
framework.
It is remarkable however, that many ideas in the
behavioral, agent-based approach in fact have quite a long
hwiesltl obrye fionr ee ctohne ormatiicosn aallr eeaxdpye cdtaattiionng s baancdk teoff ieciaerlnite r midaerkaes t
hypotheses.

Heterogeneous Agents in Finance : different heuristics and different
representations of problems

 

 

 

aRsaptieocntsa l (be.egh.a vSiaorrg heants (t1w9o9 r3e)l)a.t ed but different

First, a rational decision rule has some micro-
percionnciopmleics ,f souucnhd aatsi oenx paencdt iesd duetriliivtey do frr oexmp eocptteidm ipzraotifiot n
maximization.

Second, agents have rational expectations (RE) about
fwuittuhr ree ealviezanttiso, ntsh aatn ids ,a brealtiieofsn aal rae gpeenrtf edcotleys cnoont simstaeknet
systematic forecasting errors.

Heterogeneous Agents in Finance : different heuristics and different
representations of problems

 

 

In a rational expectations equilibrium, forecasts of
future variables coincide with the mathematical
conditional expectations, given all relevant
information.
Rational expectations provided an elegant and
parsimonious way to exclude ‘ad hoc’ forecasting rules
and market psychology from economic modelling.
Since its introduction in the sixties by Muth (1961)
and its popularization in economics by Lucas (1971),
the rational expectations hypothesis (REH) has
become the dominating expectation formation
paradigm in economics.

Heterogeneous Agents in Finance : different heuristics and different
representations of problems

 

Milton Friedman has been one of the strongest
advocates of a rational agent approach, claiming that
tdhees cbriebheadv iaosr iof ft choeny sbuemhearvse, friartmiosn aalnlyd. inTvhee sFtroiresd cmaan nb e
hypothesis stating that non-rational agents will not
sdruirvveivn eo euvt oolfu ttihoen amrya rckoetm pheatsi tipolany aend da nw iillm tphoerrteafnotr er oblee
in this discussion.

Heterogeneous Agents in Finance : different heuristics and
different representations of problems

 

In a similar spirit, Alchian (1950) argued that biological
evolution and natural selection driven by realized profits
may eliminate non-rational, non-optimizing firms and
lead to a market where rational, profit maximizing firms
dominate. The question whether the Friedman
hypothesis holds in a heterogeneous world has played an
important role in the development and discussion about
Heterogeneous Agents .

Market Efficiency

 

 

 

bAonuotnhdeerd liym rpaotritoannatl ibseshuae viino rt hise cdoisnccuesrsnieodn wofi trha tmioanrakle tv eerfsfiucsi ency, as
emphasized by Fama (1965).

If markets were not efficient, then there would be unexploited
profit opportunities, that would be exploited by rational arbitrage
traders. Rational traders would buy (sell) an underpriced
f(uonvderapmriecnetda)l avsasluete,. tIhnu as nd reifvfiicnige nitts mprairckee tb,a tchke troe tchaen cboer rneoc t,
fwooreulcda sbtea belxe psltorituecdt ubrye irna tiaosnsealt arretbiutrrnasg,e suirnsc ea nadn yt hseurcehf osrter ucture
disappear

Fama’s Efficient Markets Hypothesis (EMH), i.e. the assumption
that market behaviour can be described by a random walk process,
because rational traders do not miss unexploited profit
opportunities, has been drastically challenged by the recent
developments of “Behavioral Finance”.