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Register a new userA bright future for financial agent-based models
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The history of research in finance and economics has been widely impacted by the field of Agent-based Computational Economics (ACE). While at the same time being popular among natural science researchers for its proximity to the successful methods of physics and chemistry for example, the field of ACE has also received critics by a part of the social science community for its lack of empiricism. Yet recent trends have shifted the weights of these general arguments and potentially given ACE a whole new range of realism. At the base of these trends are found two present-day major scientific breakthroughs: the steady shift of psychology towards a hard science due to the advances of neuropsychology, and the progress of artificial intelligence and more specifically machine learning due to increasing computational power and big data. These two have also found common fields of study in the form of computational neuroscience, and human-computer interaction, among others. We outline here the main lines of a computational research study of collective economic behavior via Agent-Based Models (ABM) or Multi-Agent System (MAS), where each agent would be endowed with specific cognitive and behavioral biases known to the field of neuroeconomics, and at the same time autonomously implement rational quantitative financial strategies updated by machine learning. We postulate that such ABMs would offer a whole new range of realism.
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This short review presents a selected history of the mutual fertilization between physics and economics, from Isaac Newton and Adam Smith to the present. The fundamentally different perspectives embraced in theories developed in financial economics compared with physics are dissected with the examples of the volatility smile and of the excess volatility puzzle. The role of the Ising model of phase transitions to model social and financial systems is reviewed, with the concepts of random utilities and the logit model as the analog of the Boltzmann factor in statistic physics. Recent extensions in term of quantum decision theory are also covered. A wealth of models are discussed briefly that build on the Ising model and generalize it to account for the many stylized facts of financial markets. A summary of the relevance of the Ising model and its extensions is provided to account for financial bubbles and crashes. The review would be incomplete if it would not cover the dynamical field of agent based models (ABMs), also known as computational economic models, of which the Ising-type models are just special ABM implementations. We formulate the ``Emerging Market Intelligence hypothesis to reconcile the pervasive presence of ``noise traders with the near efficiency of financial markets. Finally, we note that evolutionary biology, more than physics, is now playing a growing role to inspire models of financial markets.
This article aims at reviewing recent empirical and theoretical developments usually grouped under the term Econophysics. Since its name was coined in 1995 by merging the words Economics and Physics, this new interdisciplinary field has grown in various directions: theoretical macroeconomics (wealth distributions), microstructure of financial markets (order book modelling), econometrics of financial bubbles and crashes, etc. In the first part of the review, we discuss on the emergence of Econophysics. Then we present empirical studies revealing statistical properties of financial time series. We begin the presentation with the widely acknowledged stylized facts which describe the returns of financial assets- fat tails, volatility clustering, autocorrelation, etc.- and recall that some of these properties are directly linked to the way time is taken into account. We continue with the statistical properties observed on order books in financial markets. For the sake of illustrating this review, (nearly) all the stated facts are reproduced using our own high-frequency financial database. Finally, contributions to the study of correlations of assets such as random matrix theory and graph theory are presented. In the second part of the review, we deal with models in Econophysics through the point of view of agent-based modelling. Amongst a large number of multi-agent-based models, we have identified three representative areas. First, using previous work originally presented in the fields of behavioural finance and market microstructure theory, econophysicists have developed agent-based models of order-driven markets that are extensively presented here. Second, kinetic theory models designed to explain some empirical facts on wealth distribution are reviewed. Third, we briefly summarize game theory models by reviewing the now classic minority game and related problems.
Much research has been conducted arguing that tipping points at which complex systems experience phase transitions are difficult to identify. To test the existence of tipping points in financial markets, based on the alternating offer strategic model we propose a network of bargaining agents who mutually either cooperate or where the feedback mechanism between trading and price dynamics is driven by an external hidden variable R that quantifies the degree of market overpricing. Due to the feedback mechanism, R fluctuates and oscillates over time, and thus periods when the market is underpriced and overpriced occur repeatedly. As the market becomes overpriced, bubbles are created that ultimately burst in a market crash. The probability that the index will drop in the next year exhibits a strong hysteresis behavior from which we calculate the tipping point. The probability distribution function of R has a bimodal shape characteristic of small systems near the tipping point. By examining the S&P500 index we illustrate the applicability of the model and demonstate that the financial data exhibits a hysteresis and a tipping point that agree with the model predictions. We report a cointegration between the returns of the S&P 500 index and its intrinsic value.
The Gaussian Process with a deep kernel is an extension of the classic GP regression model and this extended model usually constructs a new kernel function by deploying deep learning techniques like long short-term memory networks. A Gaussian Process with the kernel learned by LSTM, abbreviated as GP-LSTM, has the advantage of capturing the complex dependency of financial sequential data, while retaining the ability of probabilistic inference. However, the deep kernel Gaussian Process has not been applied to forecast the conditional returns and volatility in financial market to the best of our knowledge. In this paper, grid search algorithm, used for performing hyper-parameter optimization, is integrated with GP-LSTM to predict both the conditional mean and volatility of stock returns, which are then combined together to calculate the conditional Sharpe Ratio for constructing a long-short portfolio. The experiments are performed on a dataset covering all constituents of Shenzhen Stock Exchange Component Index. Based on empirical results, we find that the GP-LSTM model can provide more accurate forecasts in stock returns and volatility, which are jointly evaluated by the performance of constructed portfolios. Further sub-period analysis of the experiment results indicates that the superiority of GP-LSTM model over the benchmark models stems from better performance in highly volatile periods.
Management of systemic risk in financial markets is traditionally associated with setting (higher) capital requirements for market participants. There are indications that while equity ratios have been increased massively since the financial crisis, systemic risk levels might not have lowered, but even increased. It has been shown that systemic risk is to a large extent related to the underlying network topology of financial exposures. A natural question arising is how much systemic risk can be eliminated by optimally rearranging these networks and without increasing capital requirements. Overlapping portfolios with minimized systemic risk which provide the same market functionality as empirical ones have been studied by [pichler2018]. Here we propose a similar method for direct exposure networks, and apply it to cross-sectional interbank loan networks, consisting of 10 quarterly observations of the Austrian interbank market. We show that the suggested framework rearranges the network topology, such that systemic risk is reduced by a factor of approximately 3.5, and leaves the relevant economic features of the optimized network and its agents unchanged. The presented optimization procedure is not intended to actually re-configure interbank markets, but to demonstrate the huge potential for systemic risk management through rearranging exposure networks, in contrast to increasing capital requirements that were shown to have only marginal effects on systemic risk [poledna2017]. Ways to actually incentivize a self-organized formation toward optimal network configurations were introduced in [thurner2013] and [poledna2016]. For regulatory policies concerning financial market stability the knowledge of minimal systemic risk for a given economic environment can serve as a benchmark for monitoring actual systemic risk in markets.
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