Saturday, December 6, 2014

What is really interesting about Quantitative Behavioral Finance

photo by Stuck in Customs via PhotoRee

Quantitative behavioral finance has not been with out for a very long time. As a relatively recent development and area of discourse, it has only begun to gain a following. One very interesting aspect of this field is the use of experimental asset markets. These studies are based on experiments conducted on a small group of people (but with real money hence a real market) to examine where rational expectations and classical game theory fails to explain human behavior. This is basically small-scale version of the prediction markets such as the Iowa Electronic Markets, Intrade, and Betfair. However, unlike prediction markets where the ultimate objective is to predict an external event, experimental asset markets are more interested in the mechanics and patterns of the market itself. Caginalp, Vernon Smith (Nobel Memorial Economics Prize recipient of 2002), and David Porter have a couple of papers on experiments in this mode. Both experiments examine how financial bubbles can happen. Some of the take-aways are that excess cash and information asymmetry due to lack of an open book may exacerbate bubbles. I think the matter of information asymmetry is very salient. Despite all the effort and money invested in improving information infrastructure by banks and hedge funds, ultimately information is distributed non-uniformly to market participants. This is most obvious in the case of the retail investor who neither has the time nor resources to obtain and analyze all the market information.

The powerful observation in quantitative behavior finance is that not only is the Efficient Market Hypothesis incomplete, we can perturb our classic rational and game theoretic models to model behavior due to finiteness of cash and assets. A key example of this is the deviation model based on Asset Flow Differential Equations (AFDEs) in Duran's thesis.

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