Stock market model first to reproduce main properties of the real market

stock market

(PhysOrg.com) -- Since the early '90s, researchers have been developing simulations of financial markets with the goal to better understand market dynamics. While their models have improved since then to explain more features of the markets, no model has yet been able to fully reproduce the main statistical properties of financial markets in a single framework. In a new study, a team of researchers has developed an artificial stock market that, for the first time, can reproduce these main properties. Overall, the model shows how information exchange among agents can be used to understand the role of information in real markets.

The researchers, who are from various institutions in Italy, explain that their model consists of agents that are represented by nodes in a sparsely connected graph. At the beginning of the , each agent has the same amount of cash and stocks. The agents decide to trade an asset based on a value of their "sentiment" (ranging from -1 to 1, where -1 is a strong sell and 1 a strong buy). Agents’ sentiments influence each other in a unidirectional way; that is, if Agent A influences Agent B, then Agent B does not necessarily influence Agent A. The depends on the interaction between agents’ sentiments and market feedback, and is fixed each day by a clearing house mechanism. In this way, all the properties of the artificial market originate directly from the interactions among agents.

“This interaction graph is the ultimate factor in determining the dynamics of the systems, and it demonstrates the effectiveness of our model in reproducing the main properties of the real market so accurately,” Stefano Pastore of the University of Trieste told PhysOrg.com.

By performing simulations based on this model, the researchers found that the distribution of wealth tends to follow a Zipf power law distribution, where the rank of an agent is inversely proportional to the agent’s wealth. As some agents become richer than others, they start showing behaviors that reinforce their growth. For instance, agents (such as big traders and banks) that are strongly influenced by their own previous sentiment are poorly influenced by the sentiment of their neighboring agents (such as individual investors). In particular, richer agents influence a larger number of agents with a higher strength, they do not account strongly for market behavior, and they aim to conserve their opinion.

In their simulations, the researchers found that the interaction between agents’ sentiments yielded a price process that could reproduce the main properties of real markets. For example, the simulations produced fat tails of returns distributions, which can lead to large moves in the market. Another feature produced by the simulations was volatility clustering, where large changes tend to be followed by large changes. These properties and other large market trends can occur due to the collective behavior of large groups of agents, reflecting a herding phenomenon, which results from the agents' interactions driven by the information network. As Pastore explained, understanding these properties could have several applications.

“[Artificial stock markets are] mostly devoted to develop and validate of stock market models, to provide tools for volatility forecast (risk analysis), to identify optimization procedure for parameter estimations, to set-up a learning suite and Interacting and strategy game (edutainment), to perform what-if analysis (e.g., trading strategies, risk management, law and regulations), etc.,” Pastore said. “These objectives clearly point out the needs of adequate models.”


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Agent-based computer models could anticipate future economic crisis

More information: S. Pastore, L. Ponta, and S. Cincotti. “Heterogeneous information-based artificial stock market.” New Journal of Physics 12 (2010) 053035. DOI:10.1088/1367-2630/12/5/053035

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Jul 14, 2010
in other words, the stock market is a scientifically predictable fraud. Those in power know exactly how it works, and influence every one else to fall in line with their motives, which are often evil and to the detriment of the general populace.

Jul 15, 2010
the stock market is a scientifically predictable fraud. Those in power know exactly how it works, and influence every one else to fall in line with their motives, which are often evil and to the detriment of the general populace.


?? The stock market is a ... market. They simply have a model that generates statistics that look like the market, they do not generate pricing predictions. Some people have more influence than others. Warren Buffet comes to mind. How would you design a market where Warren Buffet types have no more influence than, say, an 18 year old buying his first stock? In my long travels in life, I find that the people who are out of power are often as or more evil than those in power and that wealthy powerful people often want a well working general society since their wealth depends on this.

Jul 15, 2010
Exactly, GaryB. So, stealthc, do you also rail against the "injustice" of accomplished scientists attracting more funding than random newbies just starting out?

Jul 15, 2010
So, the market is influenced by a herding behaviour?! this is disappointing... because I thought people invest because they have a view of a company, either they thought it was profiting or not. -It is now clear that they are actually following other people's opinion and example (when investing). No wonder a mere speculations can cause a market crash or a bubble.


Jul 15, 2010
Successful traders have always known this (especially technical traders).

Jul 15, 2010
"Technical analysis" bears much if not most responsibility for the herding behavior since all "technicians" (and what a godawful name that is -- makes them sound competent and scientific instead of blabbering astrologers that they are) look for the same patterns and trends in random data and they all act on them in the same manner. Oh noes, the red line dropped below the blue line, sell, sell, SELL!!!

The herd behavior is not going away in the markets or any other aspect of human lives, so might as well learn about it through these types of models. And it's not all bad -- in the short run the market may be dominated by these technical idiots, but in the long run it's dominated by actual economic growth (or actual economic collapse if you're the doomsday type).

Jul 16, 2010
Ok, the simulation set-up appears plausable and the results appear to be similar to real markets. But then what? Are we going to get new stock/option pricing algorithms based on this? Does this propose any better way to predict investment risk and price fluxuations? Is there any significant new knowledge about the herd behaviour of markets to be learned here? Nice article, altough not very surprising.

Jul 16, 2010
...there will be no one to bail them out and therefore the banks will take far fewer risks...


Long-term company risks (company collapse in 2-3 years) were and are taken by individuals in exchange for short-term personal rewards (end-of-year bonuses). The individuals taking risks couldn't care less what happened to the company after they cashed in their $20,000,000 checks. Even more likely, many of these individuals simply didn't realize the kinds of risks they were taking. Stupidity and perverse incentives are all over the place and have nothing to do with "free markets" or government bailouts. Read "The Big Short" for details.

Jul 16, 2010
Do you understand the difference between individual employees and companies? Pretend there's no government at all -- would an individual employee in a government-less world magically turn down millions for himself (without breaking the law in any way, mind you) in order to prevent potential risk to the company later on? I suppose a few might but most obviously won't.

This has nothing to do with the government. It has everything to do with the fact that perverse incentives cannot be eliminated in any kind of society where individuals interact and form complex relationships. There will always be people willing to take advantage of others. They can't be eliminated but they can be monitored and punished if found to be breaking rules.

Jul 16, 2010
That's exactly what happened. Companies were run by idiot and/or corrupt individuals that set up bonus systems that rewarded short-term performance without regard to long-term risk. These companies collapsed when that long-term risk showed up (while the individuals responsible made out like bandits). The problem is that these weren't mom-and-pop ice cream stands but multi-billion financial giants whose collapse would bring down the rest of the financial system and usher in Great Depression 2.0. Mind you, all the inter-connectedness of major banks via derivatives which made them all so vulnerable to one another was brought about by free markets, not by some government mandate.

So either you have make sure such risk-taking is prevented in the future (which is regulation) or make sure that world's financial system is not so fragile that any one collapse can bring down the whole system (which is also regulation).

Jul 16, 2010
Madoff was able to perpetuate his fraud because the SEC failed to investigate providing him a government stamp of approval.
And so the SEC was broken, however, in a free market no one would have ever questioned Madoff, nor would anyone have the authority to examine him. You defeat your own arguments with this example.

Jul 16, 2010
Please marjon, explain how the government established OTC derivatives trading and forced all the major financial institutions enter into interest rate swaps and credit default swaps with one another.

Jul 16, 2010
Actually I agree that Fannie+Freddie were part of the problem. But that in no way explains why the non-government affiliated AIG and Lehman were forced to sell CDS or invest directly in these crappy subprime mortgages which were NOT in any way guaranteed by Fannie+Freddie.

Non-govenrment affiliated Goldman and other non-government affiliated banks went to non-government affiliated rating agencies and convinced them to slap AAA on crappy mortgage tranches. These were then sold off, including to Fannie+Freddie and Lehman. And AIG then chose to sell CDS to cover these to dig itself into an even deeper hole.

Nowhere in their was the government forcing anybody to take any of those actions (except, as I agreed, they did indirectly encourage Fannie+Freddie, but that was only one part of the problem).

Jul 16, 2010
Do you give your money away without asking questions and demanding some assurance you will receive the product you are trading your money for?
Any investor could have demanded to see his books, demanded to verify all sorts of information before trusting their money with him. The customer has all the authority as it is his money. If Madoff refused, customer keeps his money. A Madoff competitor questioned Madof's performance, but was ignored by the SEC. His competitor should have shouted from the rooftops in advertising.
Nothing prevents the creation of free market agency like Consumer Reports or UL to audit financial managers.

People gave him money because he had a good reputation. In the Free Market everything runs on reputation, or so you've said in the past. I'm not going to go down this path with you again. I just wanted to show you an egregious error in your argument.

Ralph_w,

You won't get an educated debate on this topic from your opponent. I'd cut your losses w

Jul 16, 2010
Most toxic subprime loans that caused the losses were made by originate-and-sell companies like New Century, not by banks. CRA has no jurisdiction with such companies. These mortgages were made, sold off to investment banks, securitized, stamped with AAA, and then finally sold to the investors (which, sadly, did include Fannie+Freddie).

Furthermore, as recently noted in NYT, a big chunk of foreclosures and defaults is actually high-income individuals walking away from an underwater mortgage.

Jul 16, 2010
They had credit lines with regular or investment banks. They just needed a short window of time during which they tap into their credit line to allocate money for the loan, make the loan, and sell the resulting mortgage to investors directly or to an investment bank (for further securitization and resale to investors), and repay the line of credit with the proceeds. These companies were the first ones to go under during the crisis when their lines of credit were cut.

And again, these companies or their lines of credit were not in any way regulated by the CRA or any other government act. In fact, regulation that would've required loan originators to retain a big chunk of their loans on the books would've neutralized this perverse incentive of getting paid to make loans and not caring about their being repaid.

Jul 17, 2010
1) What is FMDIC?
2) Why are you bringing up FDIC? It had nothing to do with the this crisis other than preventing a massive bank run in Fall 2008 (and thank goodness for that). FDIC was established in response to the "free market" failing regulate itself and bringing on the Great Depression, and the Panic of 1907 before that, and the Long Depression before that, and so on.
3) FDIC "bails out" consumers, not companies. All the stockholders in busted banks still lose all their $$.
4) You said government involvement in the form of CRA and Fannie+Freddie was responsible. I explained to you how the crisis started and it was via unregulated companies being corrupt and/or stupid (though eventually Fannie+Freddie joined the party, which was yes, a failure of gov't oversight, but hardly responsible for the entire mess).

Jul 17, 2010
Oh I see what you did with "FMDIC" there. Congratulations, you've just created another too-big-to-fail free market entity that would dwarf AIG in its importance. Imagine if FMDIC screws up... Sure the guys responsible get fired, though they get to keep their salaries, bonuses, etc. In the meanwhile a bank run ensues and the rest of the banks go under since every single one of them gets its credibility with customers from FMDIC insurance (now non-existent) and the world collapses into yet another Great Depression.

And as I said in previous post, FDIC has had absolutely nothing to do with causing this last crisis. And FDIC has had an exemplary history of preventing financial collapses without costing taxpayers anything (all paid via bank fees), most recently in Fall of 2008. Please point out a "free market" financial institution with a similar history of 75+ years.

Jul 17, 2010
For the third time do you understand that FDIC had nothing to do with causing the crisis and had a lot to do with cleaning up its consequences? I don't care about your weird anti-FDIC campaign. I can post quotes from John freaking Stewart about how evil Goldman and the rest of "free market capitalists" are -- would that convince you that I'm right? No, it wouldn't. So why do expect that your Cato or Forbes quotes would convince me?

And yes, no kidding, FDIC had wants to eliminate too-big-to-fail. That's called regulation and that makes a hell of a lot of sense. Sadly, the current legislation failed to break up too-big-to-fail thanks to the likes of Cato and Forbes.

If you have something to say on topic on this crisis (or the stock model that is the subject of the article), then I'm all ears. If you continue to chant your anti-FDIC/CRA slogans, then I'm done with you.

Jul 17, 2010
My last reply on this thread. http://en.wikiped...l_crisis

"Some legal and financial experts note that CRA regulated loans tend to be safe and profitable, and that subprime excesses came mainly from institutions not regulated by the CRA. In the February 2008 House hearing, law professor Michael S. Barr, a Treasury Department official under President Clinton,[67][113] stated that a Federal Reserve survey showed that affected institutions considered CRA loans profitable and not overly risky. He noted that approximately 50% of the subprime loans were made by independent mortgage companies that were not regulated by the CRA, and another 25% to 30% came from only partially CRA regulated bank subsidiaries and affiliates. Barr noted that institutions fully regulated by CRA made "perhaps one in four" sub-prime loans, and that "the worst and most widespread abuses occurred in the institutions with the least federal oversight"

Jul 17, 2010
those in power and that wealthy powerful people often want a well working general society since their wealth depends on this.

A statement that could comprise a workable definition of enlightened self interest

Jul 17, 2010
a well working society can still be (and often is) a tyranny. There is no freedom, never was, and never will be.

Any smart person can see that there is no universal punishment meeted out for hurting others for self gain. In fact nature rewards the ruthless. So we will always be ruled by ruthless tyrants, and only ruthless tyrants will be inspired to rule.

Enjoy your freedoms, your democracy, and your free markets and all that other nonsense that isn't real, just like communism and magic.

Jul 18, 2010
Great!

Now we can do away with messy humans and keep the market on automatic.

- Wall Street Master Computer.

Jul 18, 2010
Been done: love your neighbor as yourself. A very simple algorithm.
That just isn't possible unless you're assuming that your neighbor and yourself are identical. Sounds like socialism to me, Marjon. Aren't you against that?

Jul 18, 2010
Socialism.
Capitalism.
Catholicism.

All are forms of religion.

One prays to the People, the other prays to Money and the last one prays to imaginary friends.

Choose the lies you want to believe.

I believe none of the above.

Jul 18, 2010
@ marjon

Quess what?

I don't believe in lies.

Duh.

Jul 19, 2010
Socialism.
Capitalism.
Catholicism.

All are forms of religion.

One prays to the People, the other prays to Money and the last one prays to imaginary friends.

Choose the lies you want to believe.

I believe none of the above.


So true

Jul 19, 2010
@ marjon

I have no beliefs.

Juste carefully weighted assumptions.

Which, understandably, are too numerous to list here...

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