Discussion Paper

No. 2019-3 | January 07, 2019
Limitations of stabilizing effects of fundamentalists: facing positive feedback traders

Abstract

The authors analyze financial interactions between fundamentalists and chartists within a heterogeneous agent model, focusing on the role of fundamentalists stabilizing prices. In contrast to related studies, which are based on simulations and calculations, they analytically prove that the presence of fundamentalists is not sufficient to avoid asset price bubbles. The behavior of trend followers with bounded leverage can result in exploding prices irrespective of fundamentalists' investment decisions. They derive upper boundaries for positive feedback traders' initial investment necessary to avoid exploding prices. In order to stabilize stock/asset markets, intervention measures might be helpful.

JEL Classification:

D84, G01, G11

Assessment

  • Downloads: 219

Links

Cite As

Michael Heinrich Baumann, Michaela Baumann, and Alexander Erler (2019). Limitations of stabilizing effects of fundamentalists: facing positive feedback traders. Economics Discussion Papers, No 2019-3, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2019-3


Comments and Questions


Anonymous - Referee Report 1
May 02, 2019 - 14:34

See attached file


Michael Heinrich Baumann - Reply to Referee Report 1
May 14, 2019 - 14:57

Dear Reviewer,

Thank you very much for your valuable report. The comments are very interesting and will help us to substantially improve our paper. In particular, we will refocus and clarify the presentation of our results. Enclosed please find our reaction to your comments. We would appreciate very much ...[more]

... the opportunity to have our paper “Limitations of stabilizing effects of fundamentalists: Facing positive feedback traders” published in Economics: The Open-Access, Open-Assessment E-Journal.


Comment 1:
First, the analysis is based on the assumption that fundamentalists always respond one period later than chartists, i.e. D_t^F=-D_(t-1)^C. That is a very strange assumption. Is there any empirical evidence for such a strong assumption? I don’t think that this assumption makes sense especially because fundamentalists are assumed to be rational. If I understand correctly, the model would always produce stable price dynamics when D_t^F=-D_t^C is assumed.

Response:
We thank the referee for pointing out this potentially important issue. We agree with the view that such an assumption would be very strong. However, the mentioned formula refers to the analytical finding that has been summarized in Theorem 5. The underlying assumption of that theorem instead can be characterized as follows:
We assumed that trend followers base their investment strategy on the price trend and that fundamentalists use the difference between the fundamental value and the market price to calculate their respective strategy. Based on this assumption, we mathematically prove that “unfortunately” fundamentalists react too slow to stabilize market prizes. On the contrary, if one would assume that fundamentalist would be fast as D_t^F=-D_t^C would presumably prevent any bubble. Additionally, it would imply that fundamentalists would neither look at the price nor at the fundamental value, but would correctly anticipate the strategy of the trend followers in order to successfully offset the price changes induced by this type of investor. From our point of view, such an assumption would be in stark contrast to the findings of the literature presented in our literature review.

To avoid a misleading interpretation, we will check and clarify our presentation in the corresponding section.


Comment 2:
Second, authors claim to be the first showing analytically that fundamentalists may not always be able to stabilize markets. Note that many other agent based financial market models have proven analytically that fundamentalists may not compensate the destabilizing power of chartists. Hence, I don’t see the contribution of the paper.

Response:
We thank the referee for addressing our potentially misleading presentation of our contribution.
Indeed, there is a vast of literature, which has time and again shown that chartists can destabilize markets despite the presence of fundamentalists. However, this aspect does not appear to be the novelty in our article. Our analysis focusses on chartists with bounded leverage – an issue that has not been taken into account adequately by the literature so far. Rather, it is often argued that markets tend to stabilize due to chartist that have run out of money before market prices will explode. In this context, we have analytically proven that even in an environment with limited access to finance, i.e. bounded leverage, the investment behavior of chartist can lead to exploding prices.

To clarify our research focus, we will reformulate the introduction and clearly hint to the aspect that our analysis explicitly considers chartist with bounded leverage.


Comment 3:
Third, the model presentation also needs to be substantially improved.

Response:
We thank the referee for this clarifying suggestion. Accordingly, we will carefully check and revise our model representation.


Anonymous - Referee Report 2
May 20, 2019 - 10:54

See attached file