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2022 | OriginalPaper | Chapter

7. Financial Instability: Re-tradable Assets and Speculation

Authors : Sabiou M. Inoua, Vernon L. Smith

Published in: Economics of Markets

Publisher: Springer International Publishing

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Abstract

The theory of competitive market price formation developed so far does not apply if the goods traded can be re-traded for capital gains, for then the stabilizing virtue of competition can be counteracted by speculation. The concept of re-tradability of a good is crucial for understanding market instability at both the macro and micro level, as directly evidenced by laboratory experiments. We offer a relatively simple model of speculative asset price dynamics that explains the excess, fat-tailed, and clustered volatility, three stylized facts of speculative asset prices.

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previous chapter Price Formation: General Equilibrium

Part of the literature review in section “Fat-Tailed and Clustered Volatility: Two Universal Empirical Regularities in the Financial Markets” and the model in Sect. 7.2 is based on Inoua (2020).

We focus on asset experiments à la V. L. Smith et al. (1988). For a review, see Porter and V. L. Smith (2003) and Palan (2013) There are other types of asset experiments: e.g., Plott and Sunder (1982) and Friedman et al. (1984). For reviews, see Noussair and Tucker (2013).

It is customary to cite the 1987 Crash as a dramatic illustration that price moves can happen absent any apparent fundamental news (Cutler et al., 1990).

Agent-based models of financial markets are reviewed by Samanidou et al. (2007) and Lux and Alfarano (2016).

In fact, since an infinite-mean process (in absolute value) does qualify as a martingale process (whose mean should be finite), the presumed neoclassical foundation of this model is uncertain.

Because nonlinearity adds no further insight to this theory, we assume these standard linear supply and demand functions, which can be viewed as first-order linear approximations of more general functions; also, since financial supply and demand can be treated symmetrically (by treating supply formally as a negative demand), one can think directly in terms of a trader’s excess demand, which is a demand or a supply, depending on the sign.

The seminal work is Kyle (1985).

As a model of expectations, the standard definition of a moving average needs to be adjusted to apply only to available realizations, which exclude of course the future realization being estimated. Then, exponential moving average expectation is just another name for adaptive expectations.

For example, if each \(a_{t}\) is drawn from an exponential distribution with mean \(\lambda\) (as in Fig. 7.7), then it can be shown that \({\mathbb{E}}({|}a_{t} {|}^{\alpha } ) = \Gamma (\alpha ){/}\lambda^{\alpha }\) (where the numerator involves the Gamma function); thus \(\alpha = 3\) is achieved for \(\lambda = 0.5503.\)

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Title: Financial Instability: Re-tradable Assets and Speculation
Authors: Sabiou M. Inoua
Vernon L. Smith
Publisher: Springer International Publishing
Book: Economics of Markets
Print ISBN: 978-3-031-08427-0

Electronic ISBN: 978-3-031-08428-7

Copyright Year: 2022
DOI: https://doi.org/10.1007/978-3-031-08428-7_7