Communication impacting financial markets

Abstract

Since the attribution of the Nobel prize in 2002 to Kahneman for prospect theory, behavioral finance has become an increasingly important subfield of finance. However the main parts of behavioral finance, prospect theory included, understand financial markets through individual investment behavior. Behavioral finance thereby ignores any interaction between participants.We introduce a socio-financial[1] model that studies the impact of communication on the pricing in financial markets. Considering the simplest possible case where each market participant has either a positive (bullish) or negative (bearish) sentiment with respect to the market, we model the evolution of the sentiment in the population due to communication in subgroups of different sizes. Nonlinear feedback effects between the market performance and changes in sentiments are taking into account by assuming that the market performance is dependent on changes in sentiments (e.g. a large sudden positive change in bullishness would lead to more buying). The market performance in turn has an impact on the sentiment through the transition probabilities to change an opinion in a group of a given size. The idea is that if for example the market has observed a recent downturn, it will be easier for even a bearish minority to convince a bullish majority to change opinion compared to the case where the meeting takes place in a bullish upturn of the market.Within the framework of our proposed model, financial markets stylized facts such as volatility clustering and extreme events may be perceived as arising due to abrupt sentiment changes via ongoing communication of the market participants. The model introduces a new volatility measure which is apt of capturing volatility clustering and from maximum likelihood analysis we are able to apply the model to real data and give additional long term insight into where a market is heading.

Three Different Ways Synchronization Can Cause Contagion in Financial Markets

“…It should now be noted that it is the changes in opinion that matter for the market performance, rather than the level of a given opinion. Empirical data supporting this idea can be found in (Andersen et al 2014a(Andersen et al , 2014b, for example. The reasoning behind this is that people having a positive view of the market would already naturally hold long positions on the market.…”

Three Different Ways Synchronization can Cause Contagion in Financial Markets

“…In the context of decision making about trading assets in financial markets, it is natural to assume that market performance itself could influence the decision making of market participants, while this could in turn influence future market performance. A model was suggested in [25] to capture this kind of feedback. The main idea is to let market performance influence decision making, rather than just going by a simple majority rule as illustrated in Figure 6.b-c.…”