TAILIEUCHUNG - Behavioral Heterogeneity in Stock Prices

A second feature of stock market return volatility which has received considerable attention is the fact that stock return volatility has a transitory (rapid decay) and a more permanent (slow decay) component. It was noted that real data on stock return has a longer memory in volatility than the one GARCH models suggest. This observation lead to the development of the component GARCH (CGARCH) models by Ding and Granger (1996) and Engle and Lee (1999). Following these papers, several studies have found that multi factor volatility models outperform single fac- tor speci cations in explaining the behavior of stock market return Importantly, two component volatility models have. | Behavioral Heterogeneity in Stock Prices H. Peter Boswijka Cars H. Hommesa Sebastiano Manzan0 June 2006 Journal of Economic Dynamics and Control forthcoming Abstract We estimate a dynamic asset pricing model characterized by heterogeneous boundedly rational agents. The fundamental value of the risky asset is publicly available to all agents but they have different beliefs about the persistence of deviations of stock prices from the fundamental benchmark. An evolutionary selection mechanism based on relative past profits governs the dynamics of the fractions and switching of agents between different beliefs or forecasting strategies. A strategy attracts more agents if it performed relatively well in the recent past compared to other strategies. We estimate the model to annual US stock price data from 1871 until 2003. The estimation results support the existence of two expectation regimes and a bootstrap F-test rejects linearity in favor of our nonlinear two-type heterogeneous agent model. One regime can be characterized as a fundamentalists regime because agents believe in mean reversion of stock prices toward the benchmark fundamental value. The second regime can be characterized as a chartist trend following regime because agents expect the deviations from the fundamental to trend. The fractions of agents using the fundamentalists and trend following forecasting rules show substantial time variation and switching between predictors. The model offers an explanation for the recent stock prices run-up. Before the 90s the trend following regime was active only occasionally. However in the late 90s the trend following regime persisted and created an extraordinary deviation of stock prices from the fundamentals. Recently the activation of the mean reversion regime has contributed to drive stock prices back closer to their fundamental valuation. Keywords heterogeneous expectations stock prices bubbles bounded rationality behavioral finance evolutionary selection. JEL .

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