A Framework for Financial Markets

Modeling and Simulation

Alessio Setzu

March 2007
Contents

Introduction ix

1 Modeling and Analysis of Financial Markets 1

1.1 Historical background . . . . . . . . . . . . . . . . . . . . . . 3
1.1.1 Classical Models . . . . . . . . . . . . . . . . . . . . . 4
1.1.2 Heterogeneous Agent Models . . . . . . . . . . . . . . 6
1.1.3 Articial Financial Markets . . . . . . . . . . . . . . . 11
1.2 How to develop an articial nancial market . . . . . . . . . . 16
1.3 Stylized Facts . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
1.3.1 Unit Root Property . . . . . . . . . . . . . . . . . . . 19
1.3.2 Fat Tails . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.3.3 Volatility Clustering . . . . . . . . . . . . . . . . . . . 21

2 A Framework for Financial Market Simulation 23

2.1 GASM Early History . . . . . . . . . . . . . . . . . . . . . . . 23
2.2 The Original Model . . . . . . . . . . . . . . . . . . . . . . . . 24
2.2.1 Agents . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.2.2 The Price Clearing Mechanism . . . . . . . . . . . . . 27
2.3 The Reengineering Process . . . . . . . . . . . . . . . . . . . . 29
2.4 Simulation Software . . . . . . . . . . . . . . . . . . . . . . . 34
2.4.1 Verication and Validation . . . . . . . . . . . . . . . 35
3 Assessing the Impact of Tobin-like Transaction Taxes 37
3.1 Motivations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3.2 Model Description . . . . . . . . . . . . . . . . . . . . . . . . 40
3.2.1 The decision making process . . . . . . . . . . . . . . . 42
3.2.2 Price clearing mechanism . . . . . . . . . . . . . . . . 47
3.2.3 Financial Resources . . . . . . . . . . . . . . . . . . . 47
3.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
3.3.1 One market . . . . . . . . . . . . . . . . . . . . . . . . 50
3.3.2 Two markets . . . . . . . . . . . . . . . . . . . . . . . 63

4 Short Selling and Margin Trading 71

4.1 Motivations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
4.2 The Extended Model . . . . . . . . . . . . . . . . . . . . . . . 75
4.2.1 non-Debt Prone Traders . . . . . . . . . . . . . . . . . 76
4.2.2 Debt Prone Traders . . . . . . . . . . . . . . . . . . . 77
4.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
4.3.1 Closed Market . . . . . . . . . . . . . . . . . . . . . . 79
4.3.2 Open Market . . . . . . . . . . . . . . . . . . . . . . . 88

5 The Interplay Among Two Stock Markets and the FOREX 92

5.1 Contagion and interdependence . . . . . . . . . . . . . . . . . 93
5.2 The Extended Model . . . . . . . . . . . . . . . . . . . . . . . 94
5.2.1 The exchange rate clearing mechanism . . . . . . . . . 95
5.2.2 The decision making process . . . . . . . . . . . . . . . 96
5.2.3 Attraction functions . . . . . . . . . . . . . . . . . . . 97
5.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
5.3.1 Foreign Exchange Market . . . . . . . . . . . . . . . . 98
 5.3.2 Two stock markets and the FOREX: putting it all to-
gether . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
5.3.3 The inationary shock . . . . . . . . . . . . . . . . . . 103

6 Conclusions 108
List of Figures

2.1 Price Clearing Mechanism. The new price p∗ is determined by the

intersection between the demand and supply curve. The gure is

drawn from a simulation. . . . . . . . . . . . . . . . . . . . . . . 28

3.1 Histogram of the distribution of daily log-returns. The gure shows

the data related to a simulation superimposed on the best normal t. 52

3.2 Survival probability distribution of logarithmic returns. The gure

shows the data related to a simulation superimposed on the best

normal t. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
3.3 Daily time series for prices (top) and returns (bottom) in the case

of a single-stock closed market. . . . . . . . . . . . . . . . . . . . 53

3.4 Estimate of the autocorrelation function of logarithmic returns (top)

and of the autocorrelation of absolute returns (bottom). . . . . . . 53

3.5 Dynamics of wealth of the four populations of traders for a simula-

tion of 2000 steps. . . . . . . . . . . . . . . . . . . . . . . . . . 57

3.6 Price variance as a function of tax rate for 10% fundamentalist and

10% chartist traders. . . . . . . . . . . . . . . . . . . . . . . . . 60

3.7 Daily time series for prices (top) and returns (bottom). . . . . . . 62
3.8 Wealth dynamics of the four trader populations for a simulation of

2000 steps, for two markets. . . . . . . . . . . . . . . . . . . . . 67

4.1 Mean and standard deviation of price variance as a function of

Random*. The percentage of DPT was varied from 0% to 100% in

steps of 25%, with m = 0.8. . . . . . . . . . . . . . . . . . . . . 80

4.2 Mean and standard deviation of price variance as a function of m. 80
4.3 Mean and standard deviation of price variance as a function of

P(in-debt), with the percentage of DP T random traders set at 50%

and m = 0.8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
4.4 Dynamics of wealth of Random and Random* for a typical simula-

tion with m = 0.8 and P (in − debt) = 50%. . . . . . . . . . . . . 82

4.5 Dynamics of wealth with trend followers for a typical simulation

with m = 0.8 and P (in − debt) = 50%. . . . . . . . . . . . . . . . 84

4.6 Volatility with a population made of 10% of DPT fundamentalists

and of 90% random traders. . . . . . . . . . . . . . . . . . . . . 85

4.7 Volatility with a population made of 5% of DPT fundamentalists,

5% of DPT momentum and 5% of DPT contrarian traders. . . . . 86

4.8 Volatility with a population made of all types of traders, both DP T

and non − DP T . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
4.9 Dynamics of wealth with all eight types of traders for a typical sim-

ulation with m = 0.8 and P (in − debt) = 50%. . . . . . . . . . . . 88

4.10 Daily time series for prices (a) and returns (b) with random traders
and σ = 10−4 . The dotted line represents the population size. . . . 90
4.11 Daily time series for prices (a) and returns (b) with 50% non−DP T
and 50% DP T random traders, with σ = 10−4 . The dotted line

represents the population size. . . . . . . . . . . . . . . . . . . . 91

5.1 Daily time series for euro-dollar exchange rate (top) and returns

(bottom). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
5.2 Survival probability distribution of standardized logarithmic returns.

The bold stars represent an estimate of the cumulative distribution

of returns related to a simulation. The solid line represents the

survival probability distribution of the best Gaussian t. . . . . . . 100

5.3 Daily time series for stock prices (top) and returns (bottom). . . . 101

5.4 Daily time series for euro-dollar exchange rate (top) and returns

(bottom). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

5.5 Wealth dynamics of the four trader populations. . . . . . . . . . . 102

5.6 Daily time series for stock prices (top) and returns (bottom). The

inationary shock is applied at the end of the step number 1000. . . 105

5.7 Daily time series for euro-dollar exchange rate (top) and returns

(bottom). The inationary shock is applied at the end of the step

number 1000. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

5.8 Daily time series for euro-dollar exchange rate (top) and volumes

(bottom). The inationary shock is applied at the end of the step

number 1000. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

5.9 Daily volatility for the stock prices between step 500 and 1500 of

the simulation. The inationary shock is applied at the end of the

step number 1000. . . . . . . . . . . . . . . . . . . . . . . . . . 106

5.10 Cross correlations of returns (top) and of absolute returns (bottom)

of the two stock price series. Each point in the horizontal axis

represents one month of trading, corresponding to 20 simulation

steps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

5.11 Covariance of returns (top) and of absolute returns (bottom) of the

stock price series. Each point in the horizontal axis represents one

month of trading, corresponding to 20 simulation steps. . . . . . . 107

List of Tables

3.1 Mean and standard error of volatility in a single market with

no tax. The results are multiplied by 103 . . . . . . . . . . . . . 55
3.2 Mean and standard error of volatility in a single market with
0.1% tax. The results are multiplied by 103 . . . . . . . . . . . 58
3.3 Mean and standard error of volatility in a single market with
0.5% tax. The results are multiplied by 103 . . . . . . . . . . . 59
3.4 Mean and standard error of volatility computed for dierent con-

trarian traders percentages, pc . The total percentage of chartists is

always 20%. All values are multiplied by 103 . . . . . . . . . . . . 61

3.5 Mean and standard error of daily volumes in a single market
with 0.0% tax. The results are multiplied by 103 . . . . . . . . 62
3.6 Mean and standard error of daily volumes in a single market
with 0.1% tax. The results are multiplied by 103 . . . . . . . . 63
3.7 Mean and standard error of daily volumes in a single market
with 0.5% tax. The results are multiplied by 103 . . . . . . . . 63
3.8 Mean and standard error of volatility in market one. The
results are multiplied by 103 . . . . . . . . . . . . . . . . . . . . 66
3.9 Mean and standard error of volatility in market two. The
results are multiplied by 103 . . . . . . . . . . . . . . . . . . . . 66
3.10 Mean and standard error of volatility in market one, with 0.1%
transaction tax. The results are multiplied by 103 . . . . . . . . 68
3.11 Mean and standard error of volatility in market two, with 0.1%
transaction tax. The results are multiplied by 103 . . . . . . . . 68
3.12 Mean and standard error of volatility in market one, with 0.5%
transaction tax. The results are multiplied by 103 . . . . . . . . 69
3.13 Mean and standard error of volatility in market two, with 0.5%
transaction tax. The results are multiplied by 103 . . . . . . . . 69
3.14 Average daily volumes. Tax levyed on market one only. The
results are divided by 103 . . . . . . . . . . . . . . . . . . . . . 70

4.1 Mean and standard error of volatility with trend followers and
random traders. The results are multiplied by 103 . . . . . . . . 83
4.2 Mean and standard error of volatility with fundamentalists and
random traders. The results are multiplied by 103 . . . . . . . . 85
4.3 Mean and standard error of volatility with fundamentalists
trend followers and random traders. The results are multi-
plied by 103 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
4.4 Mean and standard error of Volatility with random traders.
The results are multiplied by 103 . . . . . . . . . . . . . . . . 90
Introduction

Financial markets belong to the class of things that sound to be simple, but
that are indeed very complicated. They are dynamic systems made up of a
large number of economic elements engaged in continuous interactions, which
give rise to intricate aggregate regularities and to complex phenomena at the
macro level. The main result of the trading activity is price time series, that
exhibit many well known empirical properties also known as stylized facts.
In recent years, the large availability of nancial data allowed to deepen the
knowledge about price processes and, together with the new developments in
mathematics, physics and computer science, contributed to transform nance
in a quantitative science.
Researchers faced with the analysis and modeling of nancial markets
for tens of years. But classical theories, based on a single fully rational
representative agent, failed to reproduce all the properties of real markets.
Also, they have been able to make only limited progress in resolving many
important practical and policy relevant open issues, like those related to the
instability of nancial markets. In contrast, new behavioural approaches,
characterized by markets populated with bounded rational, heterogeneous
agents emerged. In recent years, this research eld has been combined with
the realm of agent-based simulation models, and a number of computer-
simulated, articial nancial markets have been built.
 This thesis presents an agent-based computer simulation framework for
building theoretical models in economics and nance. In an articial nancial
market each microscopic element of the overall system, and each kind of
interaction among them, has to be modeled and individually represented.
The computer simulation approach allows to track the evolution of each
component of the system, and to investigate on the aggregate behaviour and
to look for emergent phenomena. This approach has been already applied
in other sciences to study complex systems, and its main advantage is that
it allows to deal with issues where analytic solutions would be impossible.
The proposed model includes many realistic trading features, and has
been validated by showing that the simulated time series exhibit the main
empirical properties of real nancial markets. This articial market has been
developed using object-oriented software techniques, and is aimed to be easily
extended and composed, yielding multi-asset and multi-market simulations.
The thesis is organized as follows. Chapter 1 gives the historical back-
ground on the models in economics and nance. It also provides a brief guid-
ance in the development of an articial market, and it presents an overview
of the major statistical properties of real economic time series.
The current version of the simulation framework is the result of an in-
cremental and iteractive process: Chapter 2 summarizes its evolution, from
the original system, built on the basic ideas of the Genoa Articial Stock
Market model, until now. It also provides some details on the simulation
software, and on the verication and validation methodology.
The subsequent Chapters run through again the system evolution, and
deeply analyse the dierent versions. Each chapter introduces one major
open issue in economics and nance, then provides details on the specic
model that has been developed to study that problem, including the de-
scription of its extensions and modications in comparison with the previ-
ous version, and nally discusses the results. In particular, Chapter 3 faces
the problem of understanding the potential impact of the Tobin tax on a
multi-asset nancial market. Chapter 4 analyses the impact of margin re-
quirements and of short-sale constraints on prices and volatility, and their
connections with stock market crashes. Chapter 5 is about the interaction
between two stock markets located into two dierent countries, and their
inuence on the Foreign Exchange Market. Chapter 6 concludes the thesis
and suggests questions for the future work.
Chapter 1

Modeling and Analysis of

Financial Markets

Financial markets are at the heart of each modern economy. They can be
described as evolving complex systems, characterized by the interaction of
many simple interacting units. Today, nancial markets are continuously
monitored, and an enormous amount of electronically stored nancial data
is available. The result is an explosion of interest in this eld, that attracts
a large number of researchers attempting to model and forecast nancial
markets. It is well known that economists and mathematicians have a long
tradition in studying nancial system, but a growing number of physicists
is trying to compete with them in explaining economic phenomena. This
fact is conrmed by the emerging Econophysics research eld, which applies
theories and methods originally developed by physicists in order to solve
problems in economics. Also, the large availability of nancial data allowed
to deepen the knowledge about price processes, and many so-called styl-
ized facts have been discovered in price series, e.g., the fat tails of return
distributions, the absence of autocorrelation of returns, the autocorrelation
 2

of volatility, the peculiar distributions of trading volumes and of intervals

of trading and so on. The interest in these complex system leaded to an
unprecedented cooperation among researchers in economics, physics, math-
ematics and engineering. In recent past, people with advanced degrees in
these sciences have been employed in Wall Street to developed new nan-
cial products and new quantitative models. The result was the beginning
of a new multidisciplinary eld, called Financial Engineering, which relies
on mathematical nance, numerical methods and computer simulations to
exploit nancial opportunities, to make trading, hedging and investment de-
cisions, as well as facilitating the risk management of those decisions.
The traditional economic theory is based on simple and analytically
tractable models with a representative, fully rational agent, but this clas-
sical approach fail to reproduce all the features described above. Financial
markets are systems populated with a large number of heterogeneous agents
that interact one other using various strategies and that react to external
information trying to forecast the best price for a given asset. In recent
years, a new approach, based on heterogeneous boundedly-rational agents,
has appeared. The new approach goes beyond the limits of the classical
models, and t much better with the characteristics of real markets. The
heterogeneous agent models are usually more complex than those with a
representative rational agent, and they can be analytically untractable. So,
in the recent literature, a number of agent-based simulation models have
been developed, and computational and numerical methods have become an
important tool of analysis. In particular, over the last fteen years many
computer-simulated, articial nancial markets have been built. The arti-
cial nancial markets usually model a subset of the real macro economy or
a very specic nancial market, and they are made up of dierent ingredi-
1.1 Historical background 3

ents such as agent preferences, one or more price determination processes,

mechanisms of evolution and learning, and methods to present information
to the agents.
Articial nancial markets allow the researchers to conduct experiments,
in terms of computer simulations, to test hypotheses and to validate ideas
and conjectures. They can be employed to model the complex features of
real markets that cannot be studied analytically, and they are an important
tool for understanding how real markets works: they can help to analyse the
price dynamics, the interactions and the performances of numerous trad-
ing strategies, the relationship among various the price clearing mechanisms
and the market dynamics, but also the reactions of nancial markets to the
imposition of taxes and trading restrictions, or the economic links among
dierent markets. This work will provide answers to some of these issues.

1.1 Historical background

Economists have faced the problem of studying and modeling economic sys-
tems for hundred of years, but in the second part of the 20th century, nance
has witnessed an important revolution. The classical representative rational
agent paradigm has been replaced by a large number of agents characterized
by heterogeneous behaviours. Also, the increasing power of computers has
favored a shift from analytically tractable models with a representative agent
to complex systems, that require the implementation of simulation models
and use numerical methods as an important tool of analysis. Finally, full
rationality has been replaced by bounded rationality (see Hommes; 2002).
1.1 Historical background 4

1.1.1 Classical Models

The study of economic systems has a very long history, and some concepts
and ideas behind the models developed in recent times nd their fundamen-
tals in classical economics and nance. In the traditional approach, many
simple analytically tractable models have been developed, and the math-
ematics has been the main tool of analysis. These models makes many
assumptions regarding the economy and the individuals in order to keep
the analytical tractability, but they are often unrealistic. They are based
on the rational expectations theory and on the notion of the representative,
perfectly rational agent.
The rationality of agents is one key concepts of economics and nance.
In a full rational expectations framework, all agents make use of all available
information in determining how to best meet their objectives. The Rational
Expectation Hypothesis (REH) is a theory in economics originally proposed
by Muth (1961) and later developed by Lucas (1972). If the agents try to
forecast future variables taking into account all available information, they
will not make systematic errors, and the value of the observed variables will
be equal to the values predicted by the model, plus a random error.
The rational expectation theory provides the ground to build models
based on the notion of representative agent, having rational expectations.
A representative agent model is such that the cumulative behaviour of all
agents might as well be the actions of one agent maximizing her expected
utility function. Its origins can be traced to the 19th century, but it was
Lucas (1972) in the 1970s who really popularized the representative agent.
The only trace of heterogeneity in the rational expectations framework
resides in the fact that the agents may have dierent utility functions, but
it is not heterogeneity of beliefs, because the agents are given all relevant in-
1.1 Historical background 5

formation. Rational expectations provides an elegant and parsimonious way

to exclude ad hoc forecasting rules and market psychology from economic
modeling (Hommes; 2005).
The REH is closely linked with the nancial concept of market eciency.
The Ecient Market Hypothesis (EMH) was formulated in 1960's by Samuel-
son (1965) and Fama (1970). The EMH states that nancial markets asset
prices reect all available and relevant information useful for predicting the
future value of the assets themselves. In a ecient market, a fully rational
agent can process all available information and take optimal positions on the
markets. Under the rational behaviour and the market eciency, Samuelson
showed that the price series prior to period t are not useful to predict the
prices for periods t + 1 and beyond, because the price in period t already
reects the fundamental information of all past prices. Most of the empiri-
cal studies of the 1960s and 1970s found negligible time correlation between
price changes, so corroborating the EMH. Under the EMH, the attempt to
beat the market is a game of chance rather then skill, and if markets were not
ecient, the rational traders would exploit the arbitrage opportunity, and
any foreseeable structure would therefore disappear (see Hommes; 2005). In
other words, if investors are perfectly rational and markets are ecient, it
follows that strategies using past prices to forecast future prices, such as
technical trading, cannot be protable, except by luck. It was also generally
accepted that temporary price overreactions are due to adjustments to mar-
ket news, that spread quickly through the market and are incorporated into
prices without delay. In a such context, notions like investor sentiment or
market psychology do not make sense. Finally, in a world populated only
by rational agents that share all relevant market knowledge, the trading vol-
ume has to be low or zero, because no one can exploit for prot private
1.1 Historical background 6

positive (or negative) information in advance of everyone else.

1.1.2 Heterogeneous Agent Models

The EMH, the representative agent and rational expectations have provided
the theoretical basis for economics and nance during the seventies and large
part of the eighties. But during the eighties new ndings shook the classical
theories to their foundations (for a good review of these developments refer
to Hommes (2005)).
In that years, many empirical studies appeared showing evidence against
the EMH. One of the most important ndings was that price volatility of
many nancial time series is clustered. It means that price uctuations are
strongly temporally correlated, and that periods of low volatility are inter-
spersed with high volatility periods (see, e.g. Mandelbrot; 1963; Engle; 1982).
Moreover, the largest prices movements often happened even though little or
no news about economic fundamentals occurred (Cutler et al.; 1989). Sev-
eral authors claimed that uctuations in stock prices are too large compared
to those due to the underlying economic fundamentals (Shiller; 1981, 1989;
LeRoy and Porter; 1981), and that bubbles can be originated by the dier-
ence between real prices and fundamentals values (Summers; 1986; Campbell
and Shiller; 1988).
As said in Section 1.1.1, the EMH leads to a no trade equilibrium, and
many no trade theorems have been obtained. For instance, Milgrom and
Stokey (1982) stated that if markets are perfectly ecient, then even though
some traders may possess private information, none of them will be in a po-
sition to prot from it. The no trade assumption is clearly in sharp contrast
with the high trading volume of real markets, and represents a point against
the ecient market hypothesis.
1.1 Historical background 7

A large number of laboratory experiments rejected the hypothesis that

market participants are fully rational (Kahneman and Tversky; 1973). In
a famous paper, Smith et al. (1988) report results from several laboratory
nancial markets. They showed the occurrence of bubbles in experiments
despite the fact that information is made public, so that agents can derive
the fundamental values of the assets by backward induction.
These empirical ndings pointed out the limits of the classical theories,
and a new heterogeneous agents approach was born in order to go beyond
these limits and to explain the new observed facts in nancial time series.
Maybe one of the rst attempt to develop an heterogeneous agent model
(HAM) is the one by Zeeman (1974), which includes two kinds of traders:
fundamentalists and chartists. The model is very simple and try to explain
the temporary bulls and bears in nancial markets as a special case of the
catastrophe theory. The model is very stylized and is lacking in structural
foundations, but some basic ideas can be found also in recent models.
One of the most important models is the one proposed by Grossman and
Stiglitz, also known as the noisy rational expectations model (see Grossman;
1976; Grossman and Stiglitz; 1980). The model try to extend the EMH by
addressing the problem of costly information, by allowing the agents to know
pieces of information that are not immediately absorbed into the market.
Who obtain or analyse information faster can earn positive returns, and the
prots obtained can be used to cover the costs related to the acquisition and
the analysis of information itself.
The subsequent models departed from the EMH more and more, and
new models characterized by groups of heterogeneous agents with bounded
rationality and dierent beliefs appeared.
Beja and Goldman (1980) proposed a model with fundamentalist and
1.1 Historical background 8

trend follower (chartist) traders. They were among the rst to develop a
market maker who adjusts prices with respect of the aggregate excess de-
mand. The excess demand both of fundamentalists and chartists is computed
using linear rules. They found that if the percentage of chartist is too high
the market can become unstable, and concluded that the interaction of dif-
ferent agents with dierent behaviour could explain some features of the
dynamics of prices. Chiarella (1992) considered a non-linear extension of the
model, and showed that the non-linear system is characterized by a stable
equilibrium, but if the number of chartists is too high the price trend tends
to destabilize the system and prices exhibit periodic limit cycles.
The models introduced above represent just some examples of a huge
number of studies that analyse the interaction between chartists and funda-
mentalists, and that can be considered as a branch of the HAM also known
as the fundamentalist and chartist approach. The reported models are not
fully rational, because each group of agents does not know anything about
the other. But what happens if there are fully rational agents too? Friedman
(1953) has been the rst to argue that non rational investors cannot survive
the market competition because they will be driven out of the market by
rational investors eventually in the process of natural selection. There are
many HAM that try to test the so called Friedman's hypothesis, for instance
those that include two further kinds of traders: rational traders and noise
traders.
The notion of noise trader was introduced by Black (1986): noise traders
are individual who trade on what they think is information, but is in fact
merely noise. This idea allowed Black to justify the large volumes of trading
activity that occurs in real markets. The activity of noise traders makes
it dicult to understand what is noise and what is good information, so
1.1 Historical background 9

rational traders are obliged to look for more information without a break.
This behaviour favors large volumes and gives traders the opportunity to
earn prots by exploiting their information.
More recently, De Long et al. (1990a,b) provided evidence that noise
traders may survive in the long run, and that they may gain more money than
rational ones. They found that rational traders perceive the risk introduced
by the presence of the other traders and, under certain conditions, they
are not able to get control over the dynamics generated by the non-rational
traders. It follows that the presence of many categories of agents cannot
be considered only a temporary condition, so contradicting the Friedman's
hypothesis.
The Wall Street stock market crash in October 1987 fed the interest
in nancial market models and reinforced the idea that the classical models
based on a representative rational agent cannot explain the behaviour of real
markets. Also, new empirical studies showed that there is not direct relation
between fundamental news and stock price movements (Cutler et al.; 1989),
and that the strange behaviour of the US dollar during the mid eighties was
absolutely unrelated to economic fundamentals (Frankel and Froot; 1986).
During the seventies and the eighties there were many developments in
mathematics and physics, such as chaos theory and complex systems. These
concepts stimulated many HAM works of the eighties and of the nineties,
because they can be used to model the unpredictable price paths by using
simple laws. For instance, the models by Beja and Goldman (1980) and
Chiarella (1992) exhibit chaotic dynamics. One inuential paper is that by
Day and Huang (1990), who proposed a discrete time model with a funda-
mentalist and a noise representative agent. The model shows complicated
deviations from the equilibrium price, that are similar to real stock market
1.1 Historical background 10

uctuations with chaotic switchings between bull markets and bear market
regimes.
During the nineties an impressive number of HAMs have been devel-
oped. They explored a wide set of assumptions and proposed new kinds of
heterogeneity, in terms of new kinds of trading strategies, learning capabili-
ties, adaptive techniques, and interactions among individuals. However, the
most part of these models concentrated on behavioural assumptions while
neglecting the market structural assumptions. Structural assumptions are
those related to the structure of the market, for instance the trading proce-
dures which dene the rules of the market and the price clearing mechanisms.
Behavioural assumptions are the trading strategies and the roles by which
the traders take their decisions LiCalzi and Pellizzari (2002). Raberto (2003)
and the survey by Hommes (2005) covers the more analytic ones and those
that can be handled by means of simple numerical simulations. Some of them
are signicative and deserve a special mention because of their role in HAM
advancement. Challet and Zhang (1997) proposed a minority game model
with N agents who have to choose between two alternatives: the goal is to
be in the smallest group, that is the winner one. The model is interesting
because it is quite simple and is accompanied by a numerical description and
is suitable for analytical solutions. The minority game models share some
characteristics with nancial markets: The agents have limited resources and
rationality, they learn from the performance of past choices, a good strategy
today may become bad when others' behaviour changes, and these models
can reproduce stylized facts (Challet et al.; 2001). The model by Lux (1997,
1999) and by Lux and Marchesi (1999, 2000) succeeded in explaining four
stylized facts simultaneously: prices follow a near unit root process, there
are fat tails in the distribution of short term returns, volatility clustering
1.1 Historical background 11

and no autocorrelation of raw returns. The model is based in three popula-

tions of agents that can switch strategy in consequence of contagion eects.
They stressed the role of the market maker, that adjusts prices according to
aggregate excess demand. They addressed the issue of herding behaviour in
nancial markets, that has been also recently studied by Cont and Bouchaud
(2000) by means of random graphs and lattices.
Summing up, it is clear that the new heterogeneous paradigm is a growing
eld, that is providing answers to many issues of nancial markets, and
that goes beyond the limits of the fully rational representative agent. In a
heterogeneous world the rational agent cannot survive because, as observed
byArthur (1995) and Hommes (2001), if the world is heterogeneous, the
rational agents have to know perfectly the beliefs of all other traders, but it
seems quite unrealistic.

1.1.3 Articial Financial Markets

The heterogeneous models discussed in Section 1.1.2 either are analytically

tractable, or can by handled be means of a combination of analytical tools
and simple numerical simulations. In order to derive tractable solutions,
these models make use of many simplifying assumptions. For instance, they
do not track the behaviour of each agent individually, but they group them
into populations that can vary in size and behaviour. On the other hand,
these simplications lead to models that are not able to reproduce all the sta-
tistical features of nancial time series, and the results cannot be convincing
and lack of robustness.
The point is that the dynamics of nancial markets are not simple, and
they go beyond what can be handled analytically. In fact, the nancial
markets can be described as very large complex systems, whose dynamics
1.1 Historical background 12

depend on the behaviour and the interaction of a large ensemble of au-

tonomous traders, on the market structure and organization. There systems
exhibit emergent properties, that is, properties arising from the interactions
of the components that are not properties of the individual units themselves
(Tesfatsion; 2006).
In this context, the heterogeneity introduced in the previous section laid
the basis for studying and explaining the complex characteristics of nancial
markets, but it is not enough. The heterogeneity of agents can be expressed
in terms of wealth, strategies, learning capabilities, distribution of agents,
interactions and so on, and it unavoidably leads to produce analytically
intractable models that must be investigated numerically. Also the need to
model the market microstructure and to develop realistic price formation
mechanism contribute to add complexity to the models.
In order to address these issues, starting from the second half of the
nineties some researchers started to develop heterogeneous agent models
based on a fully computational approach. Since then, a number of computer-
simulated market models have been built (LeBaron; 2006, presents a review
of recent work in this eld).
Fortunately, the power of computers has increased enormously during
the last two decades, and this stimulated the study, the development and
the analysis of complex heterogeneous agent models with boundedly ratio-
nal agents that are based on a complete computational approach. It is worth
noting that the new behavioural approaches, characterized by markets pop-
ulated with bounded rational, heterogeneous agents using rule of thumb
strategies, t much better with agent-based simulation models, and compu-
tational and numerical methods have become an important tool of analysis.
The fully computational approach expands the realm of investigation in -
1.1 Historical background 13

nance, and proposes a methodology to face the various sources of complexity

of nancial markets. Microscopic simulation allows researchers to study mod-
els which take into account the heterogeneity of the agents, and to include
the distinguishing features of each investor. As said by Levy et al. (2000),
the strength of the microscopic simulation is that one is able to model any
imaginable investor behaviour and market structure.
The research literature often refers to agent-based models to indicate the
subset of heterogeneous agent models that make extensive use of computer
simulations. The agent-based models consider nancial markets as the re-
sult of boundedly-rational micro agents that interact and learn within the
microstructure provided by the market rules. Generally speaking, the agent-
based approach try to capture the emergence of phenomena from the micro
level to the higher macro level represented by the aggregated whole system.
For the sake of simplicity, we will use both the terms HAM and agent-based
models interchangeably, making no distinction between them.
The Santa Fe Articial Stock Market (SF-ASM) (Palmer et al.; 1994;
Arthur et al.; 1997), is one of the earliest and most inuential projects in
this set of models. The original idea was to build a nancial market with
an ecology of trading strategies, and to determine which strategies will sur-
vive, and which will fail. The market was to be an evolving system, and
new strategies could emerge from a soup of starting strategies, reinforce
themselves and maybe survive. The SF-ASM agents are endowed with lim-
ited capabilities: they have a collection of rules that guide their behaviour
on the basis of the market conditions. They have to test alternatives and
to anticipate other agents' expectations, and are obliged to continually form
individual, hypothetical, expectational models, test them, and trade trusting
the ones that predict best. In other words, the SF-ASM includes a learning
1.1 Historical background 14

and a forecasting system, and agents build their behaviour on prices and
dividends by matching specic forecasting rules and knowledge to current
market conditions. One of the main goals was to proof that market com-
plexity may be induced by the endogenous evolution of the system, rather
than exogenous phenomena. In particular, one objective was to understand
if the market converges to a tractable rational expectation equilibrium, and
to understand what happens when the market does not converge. Another
goal was to analyse the dynamics of learning and the eects on the market
equilibrium. Arthur et al. (1997) showed that if the rate of exploration of
alternative forecasts is high, the market exhibits a complex regime and a
rich psychological behaviour emerges. Periods of technical trading regime
appear, where fundamental strategies tend to be punished by the market.
The SF-ASM platform has been also extended by other researchers, such as
Joshi et al. (1998) who studied the interaction between technical and funda-
mental trading, and Tay and Linn (2001) who extended the set of classiers
of the SF-ASM by adding a fuzzy logic system. The SF-ASM is a pioneer-
ing work that has shown the way forward the creation of articial nancial
markets with heterogeneous agent. Also, it suggested that simulated price
series can be analysed to check for consistency with the stylized facts of real
data. It is worth noting that, though the SF-ASM is able to replicate these
facts qualitatively, no attempt is made to quantitatively line them up with
results from real nancial data.
The experience of the Santa Fe Articial Stock Market stimulated the
development of several other projects. For instance, Basu et al. (1998), at
Sandia National Laboratories (SNL), developed an agent-based microeco-
nomic simulation model of the US economy.
Recently, a project for developing an articial nancial market started at
1.1 Historical background 15

the Articial Intelligence Laboratory of the Massachusetts Institute of Tech-

nology (Chan; 2001). The project faces three key issues: the construction
of articial nancial markets with adaptive trading and the analysis of the
behaviour of market-making agents, the study of equilibrium conditions, and
the development of an articial market with web access. The Oxford Cen-
tre for Computational Finance (OCCF) is a recently funded research centre
which has been investigating if and how game theory can be applied in arti-
cial markets to help nancial engineers better understanding and managing
operational risk. For example, Johnson et al. (2001) developed an interesting
application of the minority game to real nancial time series.
Izumi and Ueda (1999a,b, 2001) proposed an exchange market model
with articial adaptive agents called A GEnetic-algorithm Double Auction
SImulator of TOkyo Foreign exchange market (AGEDASI TOF). The model
implements an interesting community of agents able to adapt their beliefs
with time, on the basis of information coming from various sources of news.
For each agent, the AGEDASI TOF iteratively execute ve main steps: per-
ception of prices, prediction of the future rate, submission of orders, rate de-
termination and genetic adaptation of the prediction methods. The results
show some interesting features about the emergence of clusters of strategies
and of opinion trends.
There exists an impressive mass of scientic literature on the subject of
agent-based computational economics: there are books (Levy et al.; 2000;
Tesfatsion and Judd; 2006), editorials (Lux and Marchesi; 2002) and a num-
ber of works by Hommes (2005), by LeBaron (2000, 2006) and by Tesfatsion
(2001a,b, 2002), among the others. This eort supports the idea that het-
erogeneous agent models, and the microsimulations approach, are a key tool
to model nancial markets and to reproduce the main statistical properties
1.2 How to develop an articial nancial market 16

of nancial time series.

1.2 How to develop an articial nancial market

Of course, developing an agent-based articial nancial market requires spe-

cialized knowledge and eort. One of the biggest challenges is to answer to
a large number of design questions: what types of nancial products will be
traded? What kind of agents will be used? How agents will interact with
each other? What kind of price clearing mechanism will be adopted? And
what kind of simplifying assumptions will be necessary? The list could be
long and, as observed by LeBaron (2006), there is no or little guidance in
this matter. However, the design requirements can be grouped into some
macro categories in order to make the decision process easier:

• Assets. Modern nance oers an huge number of nancial products.

Each of these has some peculiar characteristics, and they can be mod-
eled in dierent ways. The dynamics of nancial markets depend not
only on the players who buy and sell, or on the market structure, but
also on the assets that are exchanged. The main part of the literature
focuses on some major products, such as stocks, bonds, some deriva-
tives and currencies. A detailed description of these products can be
found in Bouchaud and Potters (2004).

• Agents. Three typical trader types arising in many heterogeneous

agent nancial market models are fundamentalists, chartist or techni-
cal traders, and noisy traders. Fundamentalists base their investment
decisions upon market fundamentals such as dividends, earnings, in-
terest rates or growth indicators. In contrast, technical traders pay
no attention to economic fundamentals but look for regular patterns
1.2 How to develop an articial nancial market 17

in past prices and base their investment decision upon simple trend
following trading rules. Noise traders act randomly, regardless any
specic information of the security. Their presence is sometimes nec-
essary in order to provide liquidity to the market. The majority of the
models proposed in the literature are less or more complex variants of
these basic ideas.

• Evolution and learning mechanisms. Traders can organize their

behaviour in many dierent ways, not only in terms of kinds of strategy
but also in terms of learning processes and adaptive behaviour. For
instance, they can share strategies and information, they can learn
or imitate, or they can build a network of relationships with other
participants of the market. The behaviour of traders is an example of
the dierent sources of complexity of nancial markets, as pointed out
in the stimulating paper by Pellizzari (2005).

• Price determination. One of the most critical issues is the de-

nition of the method for determining prices. Many methods exist in
real markets, and most of them fall into one of four main categories:
order book, market clearing, price adjustment and random matching
(LeBaron; 2006). The fact that stock exchange markets use dierent
price clearing mechanisms raises the question whether the market ar-
chitecture signicantly aects the price behaviour or not. Using an
agent-based articial exchange, LiCalzi and Pellizzari (2006) showed
that dierent market protocols (batch auction, continuous double auc-
tion and dealership) lead to dierent results in terms of price stability
and execution quality.

• Environment. As said by Pellizzari (2005), agents are not living in

1.2 How to develop an articial nancial market 18

a vacuum, but they act in a market environment. The environment

establishes the rules of the game not only because it denes a price
clearing mechanism, but also because it could levy taxes, regulate the
kinds of allowable exchange orders and might have a major role in the
process that produces the nal aggregate results.

These remarks point out that there are many decisions that have to be
taken in order to develop an articial nancial market model. Also, each
component adds a degree of complexity to the overall result. The are some
guidelines that could help to do the right choices. The rst one is: think big,
start small and scale fast. A good articial nancial market may become a
framework that allows to study complex and large system, with many kinds
of agents playing simultaneously in more than one market with dierent as-
sets. However, the development of such a model is not an easy task, and one
could easily get lost in it. The best solution is to outline the general architec-
ture of the system, and then develop the simplest solution that could work, in
agreement with the agile philosophy. For instance, one could start producing
a model with one kind of assets only, one kind of agents and a simple price
clearing mechanism. Then, it is possible to iteratively add complexity to
the model. The second suggestion is to make use of a suitable programming
language. The agent-based models t perfectly with the object-oriented pro-
gramming languages (Tveit; 2001; Gilbert and Bankes; 2002), which allow
to model each agent as an instance of a particular class. Also, in order to
scale fast is useful to adopt a proper software development process, such as
an agile methodology (the most famous one is eXtreme Programming (XP)
Beck; 1999; Beck and Andres; 2004), but also a powerful Integrated Develop-
ment Environment (IDE), capable to assist the developers during the whole
of software implementation. Finally, the price time series produced by the
1.3 Stylized Facts 19

articial market have to exhibit the same statistical features of real markets,
the so called stylized facts. But this is not a suggestion, it is the necessary
condition that allows to validate the model: it is a must.

1.3 Stylized Facts

It is by now well known that the economic time series of almost all nancial
assets exhibit a number of non trivial statistical properties called stylized
empirical facts. No completely satisfactory explanation of such features has
yet been found in standard theories of nancial markets, but more than fty
years of empirical studies conrm their presence. For a complete discussion
about stylized facts and statistical issues see Pagan (1996); Cont (1997);
Cont et al. (1997); Farmer (1999); Mantegna and Stanley (1999); Bouchaud
(2000) and the interesting paper by Cont (2001). There is a set of stylized
facts which appear to be the most important and common to a wide set of
nancial assets: unit root property, fat tails and volatility clustering.

1.3.1 Unit Root Property

A rst order autoregressive process is a stochastic process of the form:

x(t) = ρ · x(t − 1) + ²(t), where ρ is a coecient, and ²(t) is a station-
ary stochastic increment. The term autoregressive indicates that the process
denes a regression of x on its own past values. If ρ = 1 the process is called a
unit root process. Although the term unit root process covers a wide range of
processes, the most elementary form is the random walk with iid increments1
In particular, if ²(t) ∼ iid(0, σ 2 ), that is, ² is independently and identically
1
Here the terms random walk and unit root will be used interchangeably. With random
walk I mean a non stationary process with a unit root.
1.3 Stylized Facts 20

distributed with mean zero and variance σ 2 , the process is a random walk 2 .
Several statistical procedures have been proposed to test for the presence
of unit roots, such as the original Dickey and Fuller (1979) test and the
subsequent augmented Dickey-Fuller (ADF) test statistic (Dickey and Fuller;
1981). If x(t) = log [p(t)], where p(t) is the price of an asset at time t,
one is usually unable to reject the null hypothesis H0 : ρ = 1 against the
alternative hypothesis H1 : ρ < 1. If the logarithm of prices follows a random
walk process, the future asset prices are unpredictable based on historical
observations. Also, the volatility of prices can grow without limits in the
long run. These ndings t very well with the ecient market view of asset
price determination.

1.3.2 Fat Tails

Logarithmic returns are a measure of the relative uctuations of prices. They

are dened as r(t) = log [p(t)] − log [p(t − 1)], and are one of the most im-
portant variables in nance.
In recent years, considerable attention has been given to the distribu-
tion of asset returns. A lot of empirical data on prices and trading volumes
is available since the 1990s, and the increased calculation power of modern
computer technology has allowed researchers to conduct deep empirical anal-
ysis on nancial data. The most important nding is that the distribution
of returns is non Gaussian and heavy tailed. This result is at the odds with
the ecient market hypothesis, that implies that the probability distribution
of price returns follows a Gaussian distribution.In particular, the empirical
studies generally concur that at weekly, daily and higher frequencies, re-
turn distributions consistently exhibit non Gaussian features. On the other
2
If the distribution is a Normal one, then you have the simplest stochastic process:
Gaussian white noise
1.3 Stylized Facts 21

hand, the distribution is usually normally distributed at monthly and longer

horizons.
In the early literature, the fat tail phenomenon has been quantied by
measuring the fourth moments (kurtosis ) of the distribution. Kurtosis is the
degree of peakedness of a distribution, and is dened such that its value
is equal to zero for a Gaussian distribution. A distribution with positive
kurtosis is called leptokurtic and shows a more acute peak around the mean
and a fat tail. The distribution of the increments of asset prices is clearly
leptokurtic, but this measure is not useful for identifying the distribution of
price returns. Fortunately, recent literature established that the distribution
of returns follows a power-law or Pareto-like tail, with a tail index which is
nite, and in the range (2, 5) (often around 3).

1.3.3 Volatility Clustering

Volatility measures the amplitude of price uctuation of a nancial instru-

ment within a specic time horizon. More broadly, it refers to the degree of
(typically short-term) unpredictable change over time of a certain variable.
Volatility is often estimated by calculating the standard deviation of the
price values in a certain time window. In the time series of real stock prices,
it is observed that the variance of returns or log-prices is high for extended
periods and then low for subsequent extended periods: this phenomenon is
called volatility clustering. This fact was observed by Mandelbrot (1963),
who claimed that large changes tend to be followed by large changes, of either
sign, and small changes tend to be followed by small changes. The clustering
of volatility is also proved by the power-law decay of the autocorrelation
function of the daily volatility, typically with a small exponent in the range
γ ∈ [0.1, 0.3] (Mantegna and Stanley; 1999; Liu et al.; 1999).
1.3 Stylized Facts 22

Volatility clustering is strictly correlated with two more dependence prop-

erties of returns nancial time series: the absence of linear autocorrelation
and the presence of non linear autocorrelation.

Absence of autocorrelation in raw returns

The autocorrelation of raw returns is often insignicant, except for very small
intraday time scales. It is well known that the autocorrelation decays to zero
in less then fteen minutes for all real price time series (Cont; 2001). It seems
that this property could give support to the EMH, because one can consider
returns as independent variables. However, the absence of linear autocorre-
lation is not sucient to exclude that there is some time dependence in price
returns.

Slow decay of autocorrelation in absolute returns

The autocorrelation of absolute returns and of their square, display a positive

and slowly decaying autocorrelation, ranging from a few minutes to a several
weeks (Cont; 2001). This phenomenon can be considered as a quantitative
manifestation of the volatility clustering itself, and suggests that burst of
volatility can persist for periods that range from hours to days, weeks or
even months.
Chapter 2

A Framework for Financial

Market Simulation

2.1 GASM Early History

The GASM was born in the early 2000's at the University of Genoa. The
original project is described in Raberto et al. (2001), and the acronym means
Genoa Articial Stock Market. The name was devoted to the project's
birthplace, that in the Middle Ages was a major nancial centre, where
I.o.u. and the derivatives were invented (Briys and de Varenne; 2000).
The rst release of GASM was an articial nancial market with hetero-
geneous agents that traded on a single asset. The agents had only limited
nancial resources and adopted a simple trading strategy: they were zero
intelligence traders and issued random orders, constrained by their resources
and past price volatility. The price formation process was a clearing house,
a mechanism that determines the clearing price by crossing the demand and
the supply curves given by the current limit orders. These ingredients were
sucient to build an articial market able to reproduce the main stylized
2.2 The Original Model 24

facts of nancial markets: volatility clustering and fat tails in the distribution
of price returns.
Since then, the GASM has been extended and a number of works has
been published (see, e.g. Marchesi et al.; 2003; Raberto; 2003; Raberto et al.;
2003; Cincotti et al.; 2003, 2005). The project is being jointly developed
by Genoa and Cagliari Universities since 2005, and the ultimate goal of our
work is to develop a general framework for nancial market simulation. First,
we re-engineered the original model and the software system, and then we
extended its features and functionalities in order to address some open issues
in nancial markets.

2.2 The Original Model

This section presents the main characteristics of the original GASM we used
to develop the present release of the simulation framework. In the basic
model, only one risky asset was traded in exchange for cash. The agents had
limited resources and there were four dierent trading strategies. The price
formation process was based on the intersection of the supply and demand
curves. Note that the original GASM includes many more features than
those described in this Section, but here are discussed only those that we
used to lay the foundations of the new model.

2.2.1 Agents

Traders were segmented into four groups: random, fundamentalists, momen-

tum and contrarian traders. At each simulation step t, the generic i − th
trader issues an order with probability po = 0.02. The orders are limit orders,
whose limit price and size depend on the specic trader's strategy.
2.2 The Original Model 25

Random Traders

Random traders are characterized by the simplest trading strategy. They

are traders with zero intelligence, and issue random orders. Random traders
represent the bulk of traders who trade for reasons associated with their
needs and not with market behaviour. Zero intelligence traders are described
in many papers, following the pioneering work by Gode and Sunder (1993). If
a random trader decides to issue an order, it may be a buy or sell order with
probability 50%. The order amount is computed at random, but cannot
exceed the trader's actual cash and stock availability. In particular, the
limit price lib (t) of a generic buy limit order bi (t) issued by the i − th agent
at step t, is computed multiplying the current price p(t) of the stock by a
random number drawn from a Gaussian distribution N (µ, si ), as shown by
equation 2.1a. The limit price lis (t) of a sell order si (t) is computed fairly
symmetrically, as shown by equation 2.1b.

lib (t) = p(t) · N (µ, si ) (2.1a)

lis (t) = p(t)/N (µ, si ) (2.1b)

The mean µ is set at a value equal to 1.01 in order to have a spread be-
tween the limit prices of sell/buy orders (Raberto et al.; 2003). The standard
deviation of this distribution, si depends on the historical market standard
deviation, σi (τi ), computed on a past price series whose length, τi , depends
on each trader memory, according to equation 2.2:

si = k ∗ σ(τi ), (2.2)

where k is a constant that is usually set in the range between 3 and 4 and
τi is randomly drawn for each trader from a uniform distribution of integers
from 10 to 100 (Raberto et al.; 2003).
2.2 The Original Model 26

Fundamentalist traders

Fundamentalists strongly believe that each asset has got a fundamental price,
pf , related to factors external to the market and, sooner or later, the price
will revert to that fundamental value. The fundamental price is the same for
all fundamentalists. If a fundamentalist decides to trade, she places a buy
(sell) order if the last price p(t − 1) is lower (higher) than the fundamental
price pf . Fundamentalists' order limits are set exactly equal to pf , and their
size (in stocks for sell orders and in cash for buy orders) equals a random
fraction of the current amount of stocks or cash owned by the trader.

Momentum Traders

Momentum traders are trend followers. They play the market following past
price trends, and strictly rely on price information. Momentum traders buy
(sell) when the price goes up (down). They represent, in a simplied way,
traders following technical analysis rules and traders following a herd be-
haviour. A time window τi is assigned to each momentum trader at the
beginning of the simulation through a random draw from a uniform distri-
bution of integers in the range 10 to 50 days. If the momentum trader issues
a limit order, the limit price li (t) is set at the stock's price of the previous
time step plus an increment (decrement) proportional to the price dierence
computed in the time window τi , as shown in equation 2.3.

· ¸
p(t) − p(t − τ )
li (t) = p(t) · 1 + (2.3)
τ p(t − τ )
If the momentum trader issues a sell order, the order size is a random
fraction of the number of shares owned by the trader herself. In the case
of a buy order, the trader employs a random fraction of her cash, and the
number of demanded stocks is the ratio between that fraction and the limit
2.2 The Original Model 27

price li (t).

Contrarian traders

Contrarian traders are trend-followers too, but they speculate that, if the
stock price is rising, it will stop rising soon and fall, so it is better to sell
near the maximum, and vice versa. A time window (τi ) is assigned to each
contrarian trader at the beginning of the simulation in the same way as for
momentum traders. The contrarian trader's order limit price and quantity
are computed in the same fashion as the momentum traders, but in the
opposite direction.

2.2.2 The Price Clearing Mechanism

The price formation process is based on the intersection of the demand and
supply curves. The limit orders are all collected after each simulation step,
and the market is cleared by crossing the supply and demand curves given
by the current limit orders. The orders that are compatible with the new
price are executed, while the ones that do not match the clearing price are
discarded. The original algorithm, described in Raberto et al. (2001), is very
simple and direct and can be summarized as following.
Let be U the number of buy orders and V the number of sell orders issued
© ª
by the traders at a certain time step t = th . Also, let abu (th ), bu (th ) , u =
1, ..., U , be the data associated to the U buy orders. In each pair, the quantity
of stock to buy, abu (th ), is associated with its limit price, bu (th ). As regards
the V selling orders, they are represented by the pairs: {asv (th ), sv (th )},
v = 1, ..., V . Here the quantity to sell is asv (th ), while its associated limit
price is sv (th ). The cleared price, p∗ , is determined by intersecting the two
functions:
2.2 The Original Model 28

X
fth (p) = abu (th ) (Demand curve) (2.4)
u|bu (th )≥p

X
gth (p) = asv (th ) (Supply curve) (2.5)
v|sv (th )≤p

The orders matching the new price p∗ , i.e. buy orders with maximum price
lower than or equal to p∗ , and selling orders with minimum price higher than
or equal to p∗ , are executed. Subsequently, the amount of cash and assets
owned by each trader are updated.
Figure 2.1 shows the shape of the demand and of the supply curves in
a case derived from a simulation. The resulting clearing price p∗ is deter-
mined by the x-axis coordinate of the intersection point between the two
curves. Note that in this example the unbalance towards buy orders causes
an increase of price.

Figure 2.1: Price Clearing Mechanism. The new price p∗ is determined by the
intersection between the demand and supply curve. The gure is drawn from a
simulation.
2.3 The Reengineering Process 29

It is worth noting that in a closed market the number of shares sold

must be equal to the number of shares bought. If fth (p∗ ) < gth (p∗ ), only
fth (p∗ ) stocks will be traded. In order to equilibrate the number of stocks
exchanged, gth (p∗ ) − fth (p∗ ) stocks oered for sale at a limit price p∗ or
more are randomly chosen and discarded from the corresponding sell orders.
Symmetrically, if fth (p∗ ) > gth (p∗ ), then fth (p∗ ) − gth (p∗ ) stocks demanded
for buying by traders at a limit price less or equal to p∗ will be randomly
discarded.

2.3 The Reengineering Process

The main goal of this research has been the development of a general frame-
work for nancial market simulation. The project made use of the experience
gained with the original model, and improved its architecture and extended
its functionalities in order to build a exible and easily modiable system,
that could be rapidly adapted and extended to study, model and analyse the
plenty of open issues of real nancial markets.
The current version of the model includes both structural and behavioural
assumptions. Structural assumptions are indicative of those trading mecha-
nisms which dene the market rules, while behavioural assumptions refer to
trading strategies and the rules used by traders for making their decisions
(LiCalzi and Pellizzari; 2002). The software system obtained is exible and
easily modiable. The software framework is able to model the impact of
transaction taxes on traders' behaviour and wealth, the eects of short selling
and margin trading, the interplay of stock and option market, the interplay
between stock markets in dierent currencies, with an exchange market in
between. In fact, this framework has been developed in subsequent steps,
each one aimed to extend and generalize the previous one:
2.3 The Reengineering Process 30

1. Its rst version was able to model and simulate a stock market pop-
ulated by dierent kinds of autonomous heterogeneous agents. The
agents have nite cash and stock amounts; they issue buy/sell limit
orders basing on their behaviour and their constrained budget; both
cash and asset initial endowments are obtained applying a given law,
which can be uniform (all agents have the same initial endowment),
or can be a Zipf's law (agent's initial endowments are distributed ac-
cording to a power law, thus with big dierences among traders). In
this version of the articial stock market there was one stock, traded
in exchange for cash; the stock pays no dividend, and there are no
transaction costs or taxes. The kinds of trader behaviour implemented
in this version are: (i) random traders, who trade at random; (ii) fun-
damentalist traders, who pursue a fundamental value of the stock; (iii)
chartist traders, who follow the market, speculating that if prices are
increasing they will continue to go up, and that if prices are decreasing,
they will continue to drop; (iv) contrarian traders, who act in the oppo-
site way than chartists. In this case, the proposed model exhibited the
key stylized facts of nancial time series and was able to simulate the
long-run wealth distribution of the dierent population of the agents.

2. A second version of the framework added the possibility to introduce

taxes on transactions, and to open the market, adding or subtracting
cash to or from traders at given simulation steps, and with various
possible strategies. It was used to study the introduction of transac-
tion taxes both in a closed and in an open market (with cash inow).
Market dynamics and the traders' behaviour were studied, and in par-
ticular the distribution of wealth among dierent kinds of traders.

3. In the third version we added to traders the possibility to go short, both

2.3 The Reengineering Process 31

in stock and cash. Also, both trade margin requirements and short sale
restrictions were added. We used this version to study the eects of
this kind of trading on daily price volatility and on traders'long-run
wealth distribution.

4. A subsequent version of the framework had the ability to simulate the

interactions between stock markets and a foreign exchange market.
We enabled the framework to simulate two stock markets with dier-
ent currencies, giving traders the option to operate in one stock market
at a time, and to switch to another one if they chose to do so. A third
FOREX market was also simulated, to manage currency exchange. In
this case, the main purpose of the simulation was to analyse the inter-
action between two stock markets located in two dierent countries,
and their inuence on the FOREX market.

5. The last version of the framework was made able to simulate a stock
option market, and the underlying stock market. The main goal is
to analyse the impact of the stock option trading on the market of
the underlying security. In this case the software system has been ex-
tended introducing a new kind of trades security, the option, and two
new kinds of traders, one representing traders operating in the option
market, and the other representing the issuer of options (a bank). The
option we model is an European option, which gives the right to buy or
sell another nancial asset (underlying security ) at a specied expira-
tion date for a strike price. There are two types of options, call option
and put option. The software framework allows the owner to exercise
an option at its expiration date, of course only if it is in the money.
The option trader can buy/sell stocks in the stock market, and can
buy stock options in the option market. The bank issues options, and
2.3 The Reengineering Process 32

cover itself in the stock market when option traders exercise their in
the money options when they expire. The main goal of this version of
the framework is to analyse whether the introduction of options have
an impact on underlying asset volatility, and on wealth distribution of
traders.

The rst version of the model includes the main characteristics of the
original GASM described in section 2.2. It was a proactive work, because we
deeply analysed each component of the simulation model and we improved it
by modifying some equations, by updating the trading process and re-tuning
all the parameters. This work has been necessary to make the whole system
more exible and easily modiable. The resulting model is more robust than
the original one both in terms of changes in the parameters and in terms of
changes in the composition of the population of traders. We validated the
new model by showing that it exhibits the main stylized facts of nancial
markets, as found by using the original one. The second and the third version
of the model can be seen as improvements devoted to analyse the eects of
the imposition of dierent rules and regulations on markets. The fourth and
the fth versions explore new kinds of nancial markets, beyond the common
case of the stock markets, and their mutual interaction.
Since that the current version of the framework is the result of an incre-
mental and iterative process, we will introduce its features following the same
approach. In particular, our research originated from some policy-oriented
questions that require models with realistic behaviour, with agents capable
of reacting to institutional changes, such as the imposition of a Tobin tax on
the market. As said above, this topic leaded us to the development of the
second version of the framework. In chapter 3 we introduce the details of
the model and the results obtained with that version of the framework. For
2.3 The Reengineering Process 33

the sake of brevity, it will include the results we found with the rst version
of the model. Chapter 4 describes the improvements made to the model in
order to explore another critical question in nancial literature: the impact
of margin requirements and of short-sale constraints on prices and volatility,
and their relationship with stock market crashes. Finally, Chapter 5 is about
a further extension of the model which allowed us to analyse the interaction
between two stock markets located into two dierent countries, and their
inuence on the FOREX.
This structure has to main advantages: the rst one is that we introduce
the model details gradually, simplifying the treatment and the exposition of
the results. The second one is that each Chapter could be read separately as
a case study, without knowing anything of the details of the other Chapters.
Each one of these three Chapters is structured following the same pattern:
the rst section describes the historical background and the motivations
that leaded to each version of the framework. Then there are details about
the model itself, and the description of its extensions and modications in
comparison with the previous version. Finally, we discuss the simulation
process and the results we found.
Note that this thesis describes the results we found with versions from
one to four, while the last one will be skipped because it is in progress and is
the result of a joint work with other researchers from our group. Details on
the fth version of the model have been presented in 2006 MDEF Conference
(Ecca et al.; 2006), and then summarized in a paper submitted to a special
issue of the Computational Economics Journal.
2.4 Simulation Software 34

2.4 Simulation Software

In this section we give a brief account of the software engineering approach

used to design and develop the simulator that implements the market model
presented here. The framework is conceived to be a system in evolution,
easy to modify and to extend. In order to achieve this goal, we used an
Object Oriented language and adopted some practices from the Extreme
Programming (XP) (Beck; 1999; Beck and Andres; 2004) software develop-
ment methodology. XP is probably the most famous Agile Methodology for
software development. It can be shortly described as a set of practices and
values which encourage people to do the simplest things that could work,
rejecting the complexity and ceremony of traditional approaches. XP is an
incremental and iterative software development process, which enables to
build the software system step by step and to release new features, when
required, as soon possible. XP does not try to plan the development in
advance, but is able to adapt to requirement changing. It is based mainly
on coding, testing and refactoring, not on up-front analysis and design. A
detailed description of XP lies outside the objective of this report, but you
can nd a broad literature on this topic.
A key feature of the software framework we developed is that all its
modules are provided of automatic tests (Unit Tests ), so each system class
has a corresponding test class. All unit tests are grouped in a  test suite ,
and this is run very frequently and in an automatic fashion. In this way,
every change made to the software, in order to extend its features, to x
a bug or to improve its structure (refactoring), is followed by running the
tests. If the change introduced a bug, or undesired side eects, it is very
likely that some test fails, immediately revealing the problem and allowing
to x it. This practice leads to less time spent in nding the code responsible
2.4 Simulation Software 35

for errors, and in a higher overall quality of the system.

The software framework has been developed using Smalltalk language,
and specically Cincom VisualWorks vr. 7.4, which is freely available for
non-commercial applications. Smalltalk is a language fully Object Oriented,
with terric productivity, enabling to develop complex systems and to make
substantial modications to them very quickly, not jeopardizing quality. As
regarding performance, Smalltalk is an interpreted language, and thus, like
Java, less speedy than a compiled language like C or Fortran. However, it
is enough for our purposes, and there is not any need to trade Smalltalk
exibility for further speed. In any case, translating the framework into a
more popular OO language like Java would be straightforward, while it can
be possible also to port it to C language.

2.4.1 Verication and Validation

One of the most critical issues in developing software simulation models

is the verication and validation of the model itself. Unfortunately, there
is no a well dened technique or process to certify the correctness of a
model. Model verication usually refers to techniques used to ensure that
the computer programming and implementation of the theoretical model are
correct. The object-oriented design techniques and program modularity help
to guarantee the correctness of the simulation software (Sargent; 1994). Our
simulation software has been developed following some practices from XP
(see section 2.4), and has a modular architecture that allowed us to group
together functionally-similar classes into packages with clear behaviour and
well dened interfaces. Also, each module is supplied with a corresponding
test class that ensure the correct implementation of each operation.
Model validation consists in understanding if the computerized model
2.4 Simulation Software 36

within its domain of applicability possesses a satisfactory range of accuracy

consistent with the intended application of the model (Sargent; 1994). The
validation of economic models is a largely unexplored topic. Articial nan-
cial markets can be characterized by a large number of parameters in order
to t any kind of real data, but this approach usually leads to complicated
models, sometimes to the point to build intractable systems, or at least mod-
els extremely dicult to calibrate. On the other hand, if the framework is
too simple, it becomes analytically tractable, such those proposed by tradi-
tional economic theories. In Chapter 1 we have already shown that these
kinds of models cannot reproduce all the features of real nancial markets.
A rule of thumb is to keep the model as simple as possible, leaving out all
unnecessary components.
The problem of validation can be addressed with the requirement that
the model exhibits the main statistical properties of nancial time series,
both using dierent data from real markets and using various time horizons.
In Section 1.3 we showed that there is a set of stylized facts that is common
to a wide set of nancial assets: unit root property, fat tails and volatility
clustering. In the following Chapters we will show that our model exhibits
all these statistical properties. A further kind of validation is the conceptual
model validation. Its aim is to understand if the conceptual model is correct
and reasonable for its purpose. We performed it by presenting the model
and the results at many international conferences, and submitting papers to
economics journals (see, e.g. Mannaro et al.; 2005; Ecca et al.; 2006; Mannaro
et al.; 2006; Setzu and Marchesi; 2006). This activity allowed us to collect
meaningful suggestions and feedback on the model and on its developments.
Chapter 3

Assessing the Impact of

Tobin-like Transaction Taxes

Although the analysis of policy measures to curb speculative activity in -

nancial market attracts public attention and raises intense policy debates,
the literature on the eects of measures like the introduction of a Tobin tax
is surprisingly sparse. Part of the silence of economic theory on this issue is
due to the fact that it is not clear why volatility rises and falls, and policies
directed at reducing it are unlikely to succeed and may also have harmful
eects.
This chapter presents a study on the eects of a transaction tax on one
and on two related markets. In each market it is possible to levy a transaction
tax. In the case of two markets, each trader can choose the market where to
trade, and an attraction function is dened which drives their choice, based
on perceived protability. For the sake of brevity, this chapter joins together
the rst two versions of the articial nancial market framework (see Section
2.3).
3.1 Motivations 38

3.1 Motivations

The deep nancial crises over the past decade, starting from the Mexican
pesos crisis in 1994 to the Argentina one in 2001, raised serious doubts as to
the ability of free markets to reect the true value of a specic currency. In
fact, too many speculative activities can produce a strong bias in exchange
rates and create a monetary crisis, or at least amplify its eects. Many
observers claim that a tax on currency transactions may prove a powerful
tool for penalizing speculators and stabilizing markets. For these reasons,
in recent years there has been an ongoing interest in the idea advanced by
some economists (among whom the most famous is James Tobin; 1978) to
levy a small tax on currency transactions.
Over the last thirty years the volume of foreign exchange trading has
increased hugely. In 1973, daily trading volume averaged around $15 billion;
today, it averages $ 1.9 trillion (BIS; 2005). Moreover, 90% of the trad-
ing volume concerns short-term transactions. In general, economists believe
that most short-term transactions are of a speculative nature, and many
considered them to be a source of market volatility and instability. Instead,
medium or long term transactions are usually related to real investments.
In 1936, Keynes in The General Theory of Employment, Interest, and
Money (Keynes; 1936) asserted that the levy of a small tax on all stock
exchange transactions should contribute to reducing instability in domestic
stock markets. According to Keynes, this tax should discourage speculators
from trading, resulting in lower price volatility of the taxed asset.
In 1978, the Nobel Prize Laureate in Economics James Tobin (1978) pro-
posed the levy of a small tax (0.1%) on all foreign exchange transactions.
This would penalize short-term speculators but not long-term investors, fa-
voring market stability. Later, several authors (see, e.g. Palley; 1999; Baker;
3.1 Motivations 39

2000; Felix and Sau; 1996; Frankel; 1996; Kupiec; 1995) proposed a similar
solution for other kinds of securities.
On the other hand, some economists disagree with Keynes and Tobin's
views. Friedman (1953) challenged these theories arguing that speculative
trading could stabilize prices.
There are only a few empirical analyses on the eects of transaction taxes
on price volatility. Umlauf (1993) studied Swedish stock market data and
showed that the introduction of a Swedish tax increased the volatility of
stock prices. Its worth noting that the tax level was set at 1% in 1984 and
at 2% in 1986: such values are far too high compared with the percentage
proposed by Tobin.
Habermeier and Kirilenko (2001) analysed the eects of transaction costs
and of capital controls on markets, and showed that they can have negative
eects on price discovery, volatility and liquidity, reducing market eciency.
They produced evidence that the Tobin tax increases market volatility by
discouraging transacting, thereby reducing market liquidity.
(Palley; 2003) argues that the Tobin tax is good for nancial stability,
and that total transaction costs are not necessarily increased by its impo-
sition. Actually, transaction costs could change the composition of traders,
precluding short-term investors from the market. It leads to a reduction in
volatility and consequently in total transaction costs.
Aliber et al. (2003) demonstrated that a Tobin tax on Foreign Exchange
Transactions may increase volatility. They constructed the time series of
monthly transaction costs estimates, volatility and volume, for four curren-
cies (the British Pound, the Deutsche Mark, the Japanese Yen and the Swiss
Franc) for the period 1977 to 1999. They showed that volatility is posi-
tively correlated with the level of transaction costs, while trading volume
3.2 Model Description 40

is negatively correlated. Their results suggest that an increase in transac-

tion costs leads to a decrease in trading volume. Therefore, the eect of
the tax on volatility is exactly the opposite of what the proponents of the
Tobin tax would like to have seen. On the other hand, the ndings of Aliber
et al. (2003) were strongly criticized by Werner (2003), who argued that the
direction of causality between tax and volatility/volumes may be just the
opposite.
In The eectiveness of Keynes-Tobin transaction taxes when heteroge-
neous agents can trade in dierent markets: a behavioural nance approach
Westerho (2004a) developed a model in which rational agents apply tech-
nical and fundamental analyses for trading in two dierent markets. Their
model shows that, if a transaction tax is imposed on one market, speculators
leave this market, making it less volatile. Therefore, their model conrms
Tobin's hypothesis.

3.2 Model Description

The model is made up of an economy with two stock markets, each trading
an asset with similar characteristics, as regards prices dynamics and traders'
behaviour.
Each trader is modeled as an autonomous agent, and each is given a
given amount of cash and assets. The simulation software (see Section 2.4)
enables to track the traders' portfolio, the price series history and the orders
issued by each trader for each time step. A time step is conventionally one
day in duration.
First we examined the dynamics of a single market, both without and
with a transaction tax of 0.05% to 0.5%. Then we considered the case of
two markets, examining market trend without tax, and then the eects of
3.2 Model Description 41

introducing the tax rst in one market, and lastly in both markets.
At each time step, each trader trades only within one market. Before
trading takes place, each trader, in accordance with an attraction function
based on expected gain, may decide to leave one market, switching to the
other.
The trader model denes the basic behavioural rules for each kind of
trader. Each kind of trader is tuned setting the values of some parameters,
in such a way that the resulting price series show the well-known stylized
facts, and price volatility is similar to that found in real markets. Each kind
of trader is provided with an activity parameter that roughly controls the
activity of the trader, and her reactivity to the markets, thus inuencing the
trader's contribution to price volatility. After many trials, we were able to
introduce a parameter k common to all kinds of traders  an increase in k
leads to an increase in volatility and in volumes.
We concentrated our study on the eects of dierent compositions of
the populations behaviour on taxed (and non taxed) markets. The price
clearing mechanism we used is the same in all simulations, and is neutral
under this respect. Other works analysed market dynamics using dierent
market mechanisms and dierent trade behavioural rules in terms of stylized
facts and of allocative eciency (see, e.g. Bottazzi et al.; 2005).
We studied the case of a single market, to assess the impact of a transac-
tion tax on price volatility and traders' wealth. Then, we studied two related
stock markets, to assess the impact of levying a tax on one of them, and then
on both.
3.2 Model Description 42

3.2.1 The decision making process

The proposed model includes N traders having four dierent kinds of be-
haviour: random, fundamentalist, momentum and contrarian. At each sim-
ulation step, a trader can issue orders with a given probability, which we
usually set at 10% for every trader. In the case of two markets, each trader
chooses the most attractive market, according to her attraction function.
The behaviour of the agents is based on the equations described in Section
2.2. The main limit of the original model was that in order to obtain a good
price process the number of non random traders has to be kept very small.
As described in Raberto et al. (2003), random traders are a thermal bath,
and the number of chartist and fundamentalist traders is always less than
1%. Also, the probability that an agent will issue an order is small and equal
to 2%. We upgraded the and improved the agents' model so that the total
number of agents which use a dierent trading strategy from the random
one can reach the 30% of the total number N of agents, without inuencing
the overall price process. Also the probability that an agent issues orders
can be increased over 5-fold. This result allowed us to deeply analyse the
interactions among the various kinds of populations, in a more realistic way.

Random traders

Random traders (type R) are zero intelligence traders. We modeled them

using the equations described in Section 2.2, but we performed a sensitivity
analysis of each parameter to calibrate them. We set the window length τi
used for random traders to a value randomly chosen for each trader between 2
and 5, while the value of k was set at 1.9. These values dier somewhat from
those typically used in past simulations with the original model, that had a
longer time window, and an higher value of k . By so doing, we increased the
3.2 Model Description 43

feedback of price volatility on trader's behaviour. In this way, we obtained

more realistic price statistical behaviour in terms of stylized facts, varying
the trader population and levying various tax percentages.

Fundamentalist traders

Fundamentalists (type F) strongly believe that each asset has got an intrinsic
fundamental value pf . Fundamentalists' order limits are set toward pf , and
their size (in stocks for sell orders and in cash for buy orders) equals a fraction
of the current amount of stocks or cash owned by the trader. This size is
proportional to a term q shown in equation 3.1, where k is the same k used
for random traders in equation 2.2.

|p(t) − pf |
q=k· (3.1)
pf
When a transaction tax is levied, these computations are performed in-
creasing (or decreasing) the current price of the tax value.

Momentum traders

Momentum traders (type M) are trend-followers. If the momentum trader

issues a buy (sell) order, the limit price li is calculated as in the original
model, as shown in equation 3.2. The time window τi is draw from a uniform
distribution of integers in the range 2 to 10 days. The expected increment (or
decrement) of the price is divided by the window length, and then multiplied
by the same k used for random traders in equation 2.2. In this way, the trend
is always computed proportionally to an estimate of the derivative of prices.

· ¸
p(t) − p(t − τ )
li = p(t) · 1 + k · (3.2)
τ p(t − τ )
3.2 Model Description 44

If a transaction tax is levied, the current price p(t − 1) is adjusted adding

(or subtracting) the tax to (from) it, to account for the tax eect.
If a momentum trader decides to sell the quantity of assets that s/he
can sell qis cannot exceed the amount of assets ai (t) owned by the trader i.
If a momentum trader decides to buy, the maximum purchasable quantity
qib is limited by the cash ci (t). Both qis and qib are computed proportionally
to the absolute value of an estimate of the derivative of prices, as shown in
equations 3.3 and 3.4

· ¸
|p(t) − p(t − τ )|
qis = ai (t) · U (0, 1) · 1 + k · (3.3)
τ p(t − τ )

· ¸
ci (t) |p(t) − p(t − τ )|
qib = · U (0, 1) · 1 + k · (3.4)
pi (t) τ p(t − τ )
where U (0, 1) is a random draw from a Uniform Distribution between 0
and 1.

Contrarian traders

The contrarian (type C) trader's order limit price and quantity are computed
in the same fashion as the momentum traders, but in the opposite direction.
The transaction tax is dealt with in the same way as for momentum traders.

Attraction functions

In the case study of two markets, at each simulation step (t), the trader
decides in which market she prefers to trade by evaluating an attraction
function for both markets.
Let AT,i T,i
1 (t) and A2 (t) be the attraction functions for the i-th generic

trader of type T for the rst and the second market, respectively. At each
3.2 Model Description 45

simulation step t, the i-th trader chooses SM1 with probability given by
equation 3.5a, and SM2 with probability given by equation 3.5b.

AT,i
1 (t)
π1i (t) = (3.5a)
AT,i T,i
1 (t) + A2 (t)

π2i (t) = 1 − π1i (t) (3.5b)

The attraction functions have been designed taking into account the char-
acteristics of each sub-population of traders.
In most simulations, the trader populations of two markets do not dier
signicantly  no more than a few percentage points. However, in about 1-2%
cases, it may happen that one market becomes too attractive compared to the
other, triggering an avalanche of traders and leaving empty  or almost empty
 the other market. To avoid this divergent behaviour, we constrained the
values of the probability function π1i (t) to a minimum set at 0.3. This value
is somewhat arbitrary, but it is sucient to obviate the problem completely,
without introducing any signicant side-eect in the simulations.
As regards attraction functions, they have been designed taking into
account the specic characteristics of various kinds of traders.
Random traders represent the bulk of traders operating in the market
for personal reasons, or with no specic trading strategy. When faced with
the possibility of operating in one of two markets, they naturally tend to
prefer the less volatile one. Moreover, they also tend to avoid the market
with higher tax rate. In our model, at each simulation step random traders
choose randomly to buy or sell, with equal probability. If a random trader
decides to sell, her attraction function reects the considerations made above,
and is shown in equation 3.6.

2
AR,i
j,sell = e
σj (τi )
(1 − taxj ) (3.6)
3.2 Model Description 46

The superscript R denotes the random trader, j denotes the j-th asset,
and σj2 (τi ) represents the volatility of the returns computed in the time
window τi specic for each trader. The exponential term ensures that random
traders prefer to sell in a volatile market. The (1 − taxj ) term reduces the
attraction of a taxed market, being taxj the transaction tax imposed in j −th
market. For instance, if the tax is 1% in market j , the term taxj is set at
0.01.
If a random trader decides to buy, she performs this action in a less
volatile market with a higher probability. So, the probability that a random
trader buys in a less volatile market is equal to the probability that a ran-
dom trader sells in a more volatile one. The attraction function is given by
equation 3.7.

2
AR,i
j,buy = e
−σj (τi )
(1 − taxj ) (3.7)

Fundamental analysis requires a deep knowledge of the market. Funda-

mentalists thus tend to concentrate on a limited number of markets (Wester-
ho; 2004b). In our model, each fundamentalist issues orders in one market
only, where she is more knowledgeable, so for each of them the attraction
function of one market is one, and that of the other market is zero. The fun-
damentalist traders' population is equally divided between the two markets,
as well as their total initial wealth.
Momentum and contrarian traders are trend-followers, so they choose
the market depending on the trend of past prices. Basically they prefer the
market with the highest trend, computed in their time window τi . They
also take into account the transaction tax rate, in the same way as random
traders. These choices are reected in the attraction function reported in
3.8.
3.2 Model Description 47

|pj (t)−pj (t−τi )|

AM,i
j = AC,i
j =e
τi pj (t−τi )
(1 − taxj ) (3.8)

The exponential term ensures that the attraction functions will be always
≥ 1 so that equations 3.5a and 3.5b will not diverge.

3.2.2 Price clearing mechanism

The price clearing mechanism of each market is based on the intersection of

the demand-supply curve. We adopted the original algorithm described in
Chapter 2.

3.2.3 Financial Resources

Each agent owns a nite amount of nancial resources, that is cash and
stocks. The simulation software is able to keep track of the traders' portfolio,
and the decisions of the individual are inuenced by their limited budget.
Traders' initial endowment, both in cash and in stocks, follows a Zipf's
law. This law usually refers to the frequency of an event relative to it's rank.
George Kingsley Zipf (1949) found that the frequency of use of the English
words in texts decays as a power law of its rank. The frequency f (i) of the
i-th most common word is given by f (i) ∼ i−β , where β ' 1. A power law
y = Cx−a can be expressed by the formula: log(y) = log(C) − a · log(x),
that is a straight line with slope −a on a log-log plot. A power law decay
means that small occurrences are very common, but large ones are extremely
rare. It is worth noting that this regularity is sometimes also referred to as
Pareto. Pareto was interested in the distribution of income. Let be X a
random variable, X is said to follow a Pareto law if P (X ≥ x) = 1/xα ,
where α is a positive constant (Pareto; 1897). In other words, his law means
that there are a few millionaires and many people who make modest income.
3.2 Model Description 48

Note that a power law distribution gives the number of people whose income
is x, and not how many people have an income greater than x. It means that
the power law gives the probability distribution function (PDF) associated
with the cumulative distribution function (CDF) given by Pareto's law. The
three terms: power-law, Zipf and Pareto can refer to the same thing and, in
the case of β = 1 (or α = 1) the power-law exponent a = 2 (see, e.g. Adamic;
2000). This kind of law can be applied to many real phenomena, and holds
also for wealth (Dragulescu and Yakovenko; 2002).
The initial traders' endowment, both in cash and stocks, was obtained
by dividing agents into groups of 20 traders, and applying Zipf's law to
each group. We found that an unequal initial endowment increases trading
volumes and generates logarithmic returns with fatter tails. In the simplest
case of a market with one stock and one currency, the distribution of wealth
among traders is calculated as follows.
Let be C(0) the aggregate amount of cash at the beginning of the sim-
P
ulation C(0) = i ci (0), and A(0) the aggregate amount of stocks A(0) =
P
i ai (0). Also, let p be the average price at which the aggregate value of

stocks equals the total value of cash: p = C(0)/A(0), and let N be the
number of traders. At the beginning of each simulation, the i-th agent
is endowed with an amount of cash ci (0) = Ĉ/i and with an amount of
shares ai (0) = Â/i, where Ĉ and  are two positive constants, such that the
P
average amount of cash owned by the agents of each group 20 k=1 ck (0) is
PN
equal to C(0)/N = i=1 ci (0)/N = ci (0), and the average number of stocks
P20 PN
k=1 ak (0) is equal to A(0)/N = i=1 ai (0)/N = ai (0). We usually set

ci (0) = 50, 000 and ai (0) = 1, 000 stocks.

It is worth noting that p is the equilibrium price at which the aggregate
value of stocks equals the total value of cash value for markets with only
3.3 Results 49

random traders Raberto et al. (2003). It is the equilibrium price for a closed
market, without external inows or outows of cash. It is due to the budget
constraints, that oblige the price p(t) to oscillate around the equilibrium
value set at C(0)/A(0). Its value is linked with the mean-reverting behaviour
of the simulator, and we selected it as best unbiased fundamental price pf
used by fundamentalists.
In the case of two markets, we found that the equilibrium price depends
√ P
on the square root of the number of markets: p ' m · C(0)/ m i=1 Am (0),

where m is the number of markets. In this case each trader is given with an
average 1, 000 stocks per market, and $70,500.

3.3 Results

In this section we describe the results of the computational experiments we

performed. We studied the eectiveness of the Tobin tax in two steps. In
section 3.3.1 we discuss one market only, rst without the tax, then levying
a tax rate between 0.05% and 0.5% on each transaction. In section 3.3.2 we
discuss two markets, rst with no tax applied, and then applying the tax to
the rst.
We performed numerous simulations for all cases. Each simulation is usu-
ally run with 4, 000 time steps (corresponding to a time span of 16 years),
and with 400 agents, each with a probability p = 0.1 to trade at each time
step. We also performed some simulation runs with 4000 agents, each with
a probability p = 0.01 to trade at each time step. In this way, the average
number of market transactions is the same as the previous case, but each
trader places on average ten times less transactions, thus maintaining virtu-
ally unchanged her wealth, irrespectively of the trading strategy and of the
tax.
3.3 Results 50

For each trader conguration we performed 20 runs. In some cases, we

also performed 50 runs, but we never found results to dier signicantly from
those obtained with 20 runs.

3.3.1 One market

As described in the following three Sections, we rst tested the overall be-
haviour of our model, varying the percentage of fundamentalists from zero
to 30%, in steps of 10, and the percentage of chartists from zero to 30% in a
similar fashion. Note that chartists always comprise the same percentage of
momentum and contrarian traders. Then we tested our model keeping the
percentage of fundamentalists (20%) and of chartists (20%) unchanged but
varying the percentage of momentum versus contrarian traders in 5% steps.

Stylized Facts

First, we tested for the presence of the stylized facts broadly explained in
Section 1.3. The results are in agreement with those of the original version of
the GASM (see Raberto; 2003), so this Section provides just concise summary
of the main ndings. For the sake of brevity, the following Chapters will not
report details on the stylized facts, except for those cases which deserve a
special mention. Price series show the usual stylized facts, with fat tails of
returns and volatility clustering. Note that, as discussed in section 3.2, the
trader models are not the same as previous reported simulations, but now all
depend on the same coecient k , able to control traders' reaction to price
trend, and thus to tune market volatility. After many test runs, we set the
value of k at 1.9, which guarantees the appearance of the price series stylized
facts for virtually every trader composition used.
In Figure 3.1 we plot the histogram of daily log-returns. A best-t normal
3.3 Results 51

distribution is superimposed; its narrow peak is well dened and is typical of

all simulations we ran. Figure 3.2 shows the survival probability distribution
of the standardized logarithmic return. The solid line represents the survival
probability distribution of the best Gaussian t and the bold stars that of the
returns. The deviation from Gaussian distribution shows again a leptokurtic
behaviour in the returns tail, with a very well dened power-law behaviour
for high values of returns. We found that the tail of the empirical survival
probability distribution follows a power law, with a slope that is always in
the interval [3, 5].
Figure 3.3 shows the simulated stock price path (top) and logarithmic
returns (bottom) of a typical simulation. This gure emphasizes the volatil-
ity clustering phenomenon, and the mean-reverting behaviour of the price
path in the long-run. We tested for the presence of a unit root, according to
the Augmented Dickey-Fuller test (see Dickey and Fuller; 1979, 1981). The
null hypothesis of a unit root is rejected at the signicance level of 1%. This
result is in agreement with the results found by Raberto (2003), and is due
to the fact that we analysed a closed market, with a strong mean-reverting
behaviour. A real market cannot be considered a closed system, but it heav-
ily interacts with the economy, interest rates external events and so on. It
is worth noting that the unit root hypothesis is recovered in the case of an
open market. In the case of an open market the null hypothesis of a unit
root cannot be rejected. These results have been explained in Raberto (2003)
and, for the sake of brevity, they are not reported here. Finally, gure 3.4
shows the autocorrelation function of raw returns and of the absolute val-
ues of log-returns: the rst one quickly decays to zero, but the second one
exhibits a slow decay and the presence of long-range correlations.
3.3 Results 52

25

20

15
Density

10

0
−0.25 −0.2 −0.15 −0.1 −0.05 0 0.05 0.1 0.15 0.2 0.25
Returns

Figure 3.1: Histogram of the distribution of daily log-returns. The gure shows the
data related to a simulation superimposed on the best normal t.

0
10

−1
10
ER > |Ret|

−2
10

−3
10

−3 −2 −1
10 10 10
|Ret|

Figure 3.2: Survival probability distribution of logarithmic returns. The gure

shows the data related to a simulation superimposed on the best normal t.
3.3 Results 53

80

70

60
Prices

50

40

30
0 500 1000 1500 2000 2500 3000 3500 4000
Time

0.2

0.1
Returns

−0.1

−0.2
0 500 1000 1500 2000 2500 3000 3500 4000
Time

Figure 3.3: Daily time series for prices (top) and returns (bottom) in the case of
a single-stock closed market.

returns
1
Sample Autocorrelation

0.5

−0.5
0 10 20 30 40 50 60 70 80 90 100
Lag

absolute returns
1
Sample Autocorrelation

0.5

−0.5
0 10 20 30 40 50 60 70 80 90 100
Lag

Figure 3.4: Estimate of the autocorrelation function of logarithmic returns (top)

and of the autocorrelation of absolute returns (bottom).

One market with no transaction tax

When the tax is not levied in a closed market, we obtained results similar to
those reported in Raberto et al. (2003), with fundamentalists and contrarian
3.3 Results 54

traders gaining wealth with time, at the expense of momentum traders and,
to a lesser extent, of random traders.
Here we describe the results of several simulations performed varying the
percentage of fundamental and chartist traders from 0% to 30% in steps of
10%, the remainder being random traders. Table 3.1 shows the mean and
standard error of price volatility, computed for the case of no Tobin tax.
Volatility of the returns was computed as the variance during period T :

T
1 X
σr2 = (rt − r̄)2 (3.9)
T −1
t=1

where rt = ln(p(t)) − ln(p(t − 1)) represents the logarithmic returns at

the instant t. We always omitted to include the rst 250 simulation steps
in price volatility computation, to accommodate possible initial transient
eects on price volatility. Note that all values reported in tables from 3.1 to
3.13 are multiplied by 103 .
As regards the width of time window T , we performed various tests,
varying T between 5 and 50 time steps. In all cases, irrespectively of trader
composition and tax value, we found very stable average price variance val-
ues, slowly decreasing with T . The percentage dierence of average price
volatility between T = 5 and T = 50 is always below 12%. We then decided
to use the value T = 10, which guarantees the best trade-o between low
and high values of the time window used to compute price volatility.
The results of the simulations are reported in Table 3.1. In these runs,
price volatility decreases as the percentage of chartists increases, and in-
creases as the percentage of fundamentalists decreases. These results are
fairly robust and repeatable, because the presented gures are each averaged
over 20 runs, and their standard error is usually much lower than volatility
itself. Since they are not obvious, we will discuss them in detail.
3.3 Results 55

Table 3.1: Mean and standard error of volatility in a single market with no
tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 10% 20% 30%

0% 1.61 (0.21) 0.78 (0.10) 0.46 (0.07) 0.19 (0.01)

10% 4.33 (0.44) 1.42 (0.16) 0.49 (0.03) 0.22 (0.01)

20% 7.31 (0.62) 2.41 (0.31) 0.60 (0.06) 0.27 (0.04)

30% 15.17 (0.99) 2.94 (0.33) 1.00 (0.10) 0.26 (0.02)

In the presented model, random traders alone are able to create consistent
price volatility, for two main reasons:

• their wealth is distributed according to Zipf's law, so from time to

time the wealthiest traders place large orders, that are able to generate
signicant price variations;

• the limit price of orders is randomly chosen, according to a Gaussian

distribution with variance depending on past price volatility; this in-
troduces a GARCH-like eect, able to yield volatility clustering and to
increase overall price volatility.

On the other hand, chartists are composed equally of momentum and

contrarian traders. While momentum traders can destabilize the market,
and thus increase its volatility, contrarian traders tend to stabilize it, and
basically counteract the eect of momentum traders. The joint behaviour
of both populations tends to stabilize the market, with respect to the eect
of random traders, whose number decreases as the total number of chartists
increases.
3.3 Results 56

As regards fundamentalists, price volatility increases sharply as their per-

centage increases. This phenomenon is related with the prompt intervention
of fundamentalists when prices diverge from their fundamental value. In
practice, occasional major price variations caused by large orders placed by
random traders, with a limit price that diers substantially from the current
price, are immediately counter-acted by fundamentalists, strength being pro-
portional to the original variation. This behaviour drives prices toward the
fundamental value, thus adding volatility to the system. Indeed, fundamen-
talists can be seen as short memory traders, since they only look at the
last price realized. The destabilizing behaviour of short memory traders is
in line with the ndings of other agent-based investigations.
In Fig. 3.5 we report the dynamics of wealth of the four populations
of traders for a simulation of 2000 steps. Here both fundamentalists and
chartists account for 10% of total trader population. Fundamentalists and
contrarian traders tend to increase their wealth at the expense of momentum
traders and, to a lesser extent, of random traders, conrming again the
results reported in Raberto et al. (2003) The decreasing wealth of momentum
traders, however, does not substantially aects their behaviour and their
eect on the price.

One market with transaction tax

Here we show the eects of the tax on a single market. We performed

numerous runs, varying the percentages of trader populations and tax rate.
The tax rate is set at 0.1% and 0.5%. The former gure is within the range
usually proposed and discussed by supporters and detractors of a transaction
tax, while the latter gure is much higher, and is used to analyse the eects
of an amplied tax. Note that, since both buyer and seller pay the tax, all
3.3 Results 57

5
x 10
1.6
contrarian

1.5 fundamentalist

momentum
1.4 random

1.3

1.2
Wealth

1.1

0.9

0.8

0.7
0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time

Figure 3.5: Dynamics of wealth of the four populations of traders for a simulation
of 2000 steps.

these gures should be doubled.

Introducing the tax in one market made it possible to analyse a number
of issues debated among its supporters and detractors. Namely, whether the
taxed market becomes stabler or not, and how volatility and trading volumes
change. In all reported cases, the simulations show the stylized facts of price
series (return autocorrelation, fat tails, volatility clustering).
The results show the price volatility, and its standard error, averaged over
20 runs each. The simulations were performed using 400 traders and 2000
time steps, varying the percentages of trader populations as in the previous
section.
Since our market model has nite resources, levying a tax leads to a
reduction of total traders' wealth with time, that may be signicant for the
highest tax rates. To compensate for this eect, we computed the cash
outow due to the tax every 100 steps, and gave randomly chosen traders
3.3 Results 58

small amounts of cash totalling their cash outow.

Table 3.2 shows mean and standard error of price volatility, computed
for a Tobin tax of 0.1%. In this case, for low (10%) or zero chartist percent-
age, there are no signicant dierences compared to the no tax market. As
the chartist percentage increases, however, volatility increases substantially
except when no fundamentalists are included. This increase may be as much
as 80%, for the largest percentage of fundamentalist and chartist traders.

Table 3.2: Mean and standard error of volatility in a single market with 0.1%
tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 10% 20% 30%

0 1.62 (0.14) 0.70 (0.04) 0.45 (0.04) 0.28 (0.03)

10% 3.71 (0.33) 1.35 (0.14) 0.60 (0.07) 0.31 (0.01)

20% 7.78 (0.79) 2.44 (0.25) 0.74 (0.08) 0.36 (0.03)

30% 14.44 (1.35) 2.99 (0.28) 1.32 (0.16) 0.56 (0.04)

Table 3.3 shows mean and standard error of price volatility, computed
for a Tobin tax of 0.5%.
For markets with random and fundamentalists traders alone, levying the
tax produces a small reduction in volatility, which varies with fundamentalist
percentage, attaining 5-8% (tax = 0.1%), and as much as 30-40% (tax =
0.5%).
When chartists are taken into account, the tax systematically leads to
an increase in volatility, of up to 80% for tax = 0.1%, and of up to 7-fold for
tax = 0.5%, for the highest percentage of chartists. This eect is evident for
a chartist percentage of 20% or 30%. When chartists only account for 10%
of the entire trader population, the increase in volatility is signicant only
3.3 Results 59

Table 3.3: Mean and standard error of volatility in a single market with 0.5%
tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 10% 20% 30%

0 1.06 (0.16) 0.85 (0.09) 0.66 (0.03) 0.71 (0.04)

10% 3.06 (0.41) 1.36 (0.12) 1.15 (0.10) 1.04 (0.09)

20% 5.74 (0.56) 2.73 (0.25) 1.89 (0.15) 1.55 (0.11)

30% 11.05 (0.64) 5.51 (0.28) 3.12 (0.24) 2.25 (0.12)

for 30% fundamentalists. In general, when chartist are included, increasing

the percentage of fundamentalists further increases the volatility when the
tax is levied.
To gain more insight into this behaviour, we performed several runs with
a market model composed of 10% fundamentalists, 5% momentum traders
and 5% contrarian traders, varying the tax from 0 to 1% with steps of 0.025%.
Each tax percentage has been simulated 10 times, and the resulting price
variances averaged. The results shown in Figure 3.6 clearly indicate the
steady increase in volatility, despite the noise in measurements, conrming
the results reported above.
Using this model, price volatility increases steadily with tax rate, pro-
vided that the percentage of chartists is suciently large. When chartists
are excluded, price volatility tends to decrease slowly with increasing tax
rate. These results are in agreement with the empirical ndings reported by
Umlauf (1993) and by Aliber et al. (2003), who observed a price volatility
increase with tax rate (or, better, with transaction costs).
We conducted further tests keeping the percentage of fundamentalists
(20%) and of chartists (20%) unchanged, but varying that of momentum
3.3 Results 60

−3
x 10
8

5
Volatility

1
0 0.001 0.002 0.003 0.004 0.005 0.006 0.007 0.008 0.009 0.01
Tax

Figure 3.6: Price variance as a function of tax rate for 10% fundamentalist and
10% chartist traders.

versus contrarian traders in 5% steps.

The results of these simulations are shown in Table 3.4. We found volatil-
ity increased with tax rate in all cases, but when contrarian traders were
omitted. With this model, an extreme chartist composition, made up of
contrarian or momentum traders alone, seems to increase volatility, while
more balanced compositions result in lower volatility. Momentum traders
tend to increase volatility more, especially when no tax, or a small tax, is
levied.
Figure 3.7 shows the daily time series of logarithmic price returns for a
typical simulation having a trader population composed of 20% fundamen-
talist, 10% momentum, 10% contrarian, for a 0.05% tax rate. Note that
prices always oscillate around 50. This is due to the fact that the nite
amount of cash and stocks induces mean-reversion on prices around a con-
stant long-run mean which depends on the ratio of the total amount of cash
3.3 Results 61

Table 3.4: Mean and standard error of volatility computed for dierent contrarian
traders percentages, pc . The total percentage of chartists is always 20%. All values
are multiplied by 103 .

T ax pc =20% pc =15% pc =10% pc =5% pc =0%

rate % Mean (stEr) Mean (stEr) Mean (stEr) Mean (stEr) Mean (stEr)

0.0 1.83 (0.13) 0.62 (0.07) 0.58 (0.06) 1.15 (0.11) 4.88 (0.46)

0.1 1.96 (0.28) 0.95 (0.08) 0.71 (0.07) 1.25 (0.09) 4.31 (0.26)

0.5 4.70 (0.31) 2.26 (0.14) 1.84 (0.14) 2.20 (0.19) 4.78 (0.26)

to the total number of shares (Raberto et al.; 2003). Moreover, the funda-
mental price p(f ) of fundamentalist traders is set to 50 to be consistent with
the mean reverting behaviour. The increase of volatility could be explained
by the reduction of orders when a tax is applied. Note that we have 400
agents, and on average 40 active agents at each time step, resulting in an
average of 20 sell orders and 20 buy orders of dierent sizes. If transac-
tion taxes reduce these numbers, and also the agents' trading amount, the
demand and supply curves from which the price is derived becomes much
fuzzier, magnifying price variations. The relationship between transaction
taxes, market depth and price volatility is also explored by Ehrenstein et al.
(2005), yielding similar results.
In Tables 3.5, 3.6 and 3.7, we report the average daily volumes for the
cases studied. The traded volumes do not change as much as volatility as
trader composition and tax rate are varied. However, note the strong anti-
correlation between volatility and volumes in many cases.
Westerho (2003), using a dierent model with unlimited resources ob-
served a dierent behaviour  a reduction in volatility for low tax rates,
increasing as rates are increased. These results conrm how dicult it is to
3.3 Results 62

70

65

60

55
Price

50

45

40

35
0 500 1000 1500 2000 2500 3000 3500 4000
Time

0.2

0.1
Returns

−0.1

−0.2
0 500 1000 1500 2000 2500 3000 3500 4000
Time

Figure 3.7: Daily time series for prices (top) and returns (bottom).

Table 3.5: Mean and standard error of daily volumes in a single market with
0.0% tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 10% 20% 30%

0% 9.51 (0.91) 10.04 (0.96) 10.63 (1.00) 11.17 (1.06)

10% 8.02 (0.75) 8.69 (0.83) 9.28 (0.90) 9.94 (0.97)

20% 6.92 (0.65) 7.54 (0.74) 8.19 (0.82) 8.76 (0.89)

30% 5.80 (0.56) 6.43 (0.66) 7.12 (0.75) 7.69 (0.83)

assess the impact of a change in market regulation using a theoretical model,

suggesting further studies are warranted to gain a greater insight into market
behaviour.
3.3 Results 63

Table 3.6: Mean and standard error of daily volumes in a single market with
0.1% tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 10% 20% 30%

0% 9.51 (0.91) 9.82 (0.93) 10.07 (0.96) 10.18 (0.99)

10% 8.06 (0.75) 8.41 (0.80) 8.75 (0.85) 8.91 (0.90)

20% 6.85 (0.64) 7.27 (0.71) 7.57 (0.77) 7.70 (0.82)

30% 5.76 (0.55) 6.16 (0.64) 6.44 (0.69) 6.57 (0.74)

Table 3.7: Mean and standard error of daily volumes in a single market with
0.5% tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 10% 20% 30%

0% 9.87 (0.88) 9.30 (0.85) 8.82 (0.85) 8.41 (0.88)

10% 8.16 (0.73) 7.78 (0.72) 7.35 (0.73) 7.01 (0.76)

20% 6.88 (0.63) 6.57 (0.64) 6.19 (0.65) 5.88 (0.67)

30% 5.73 (0.55) 5.44 (0.56) 5.15 (0.58) 4.87 (0.61)

3.3.2 Two markets

In this subsection we discuss the second part of our experiment. We analysed

two markets rst levying no transaction tax and then introducing the tax in
one market, leaving the other untaxed. The rules enabling traders to switch
from one market to the other are described in Section 3.2.1. We recall that
fundamentalist traders do not switch between markets.
Traders' initial cash and stock endowment was chosen with the constraint
that wealth was balanced in the two markets. We performed a number of
3.3 Results 64

simulations varying fundamentalist and chartist percentages between 0 and

20, maintaining the same percentage of momentum and contrarian traders.
In this way, we had a thermal bath of random traders, and at the same time
a suciently large number of other kinds of traders to make their inuence
felt in the price dynamics.
The number of traders used in each simulation was 4000, with a 2%
probability of trading at each time step. In this way, we were able to generate
for each market the same average number of orders as the simulations for a
single market. Note that we had 400 traders in the single market simulations,
with a 10% probability of trading at each time step. The much larger number
of traders was chosen so as to minimize any possible side-eects caused by a
wealth increase or reduction for specic trader kinds.
Each conguration was simulated 20 times, using 2000 time steps each,
and we computed the average price variance (volatility) and the standard
error of this variance, to assess price volatility data consistency. The variance
has been computed for intervals of 10 time steps, discarding the rst 250
steps, as in previous runs.

Two markets: no transaction tax

Here we examine the dynamics of two markets with no transaction tax.

When no tax is levied in either of the closed markets, we obtain the clas-
sical stylized facts (returns autocorrelation, fat tails, volatility clustering),
observed for the single market. For the sake of brevity, these results are not
reported here.
Tables 3.8 and 3.9 give the mean and the standard error of price volatility,
computed for the case of no Tobin tax, varying the percentages of fundamen-
talists and chartists.
3.3 Results 65

The price volatility values conrm that both markets behave in the same
way. Moreover, in this case the number of traders switching from one mar-
ket to another, and vice-versa, are balanced in both markets. Volatility is
somewhat higher than in the corresponding Table 3.1, denoting that the pres-
ence of two markets, with traders switching between them, tends to increase
price volatility. Again, price volatility decreases with increasing percentages
of chartists, and increases with increasing percentages of fundamentalists.
These experiments conrm the ndings obtained for single markets and two
markets with no tax. The rst observation is that having two markets leads
to a substantial increase in price volatility. This phenomenon might be ex-
plained by the imbalance between cash and stocks with respect to a single
market. However, we performed a number of simulations with one market,
varying traders' initial cash endowment, while leaving their stock endowment
unchanged, but did not notice any change in volatility. Note that volatility
increases 3-4 fold even for markets with just random traders, who switch
from one to the other trying to reduce their risk. They tend to sell in the
more volatile market, and buy in the less volatile one, as shown in equations
3.6 and 3.7 (section 3.2.1). Probably, this behaviour creates an imbalance in
orders resulting in an overall increase in volatility. The intrinsic mean rever-
sion mechanism due to limited trader resources avoids long-term imbalance
between the two markets. The presence of fundamentalists seems to reduce
the increase in volatility, while the combined presence of high percentages
of chartists and fundamentalists magnies it  for 20% fundamentalists and
20% chartists, we observed a 8-9 fold increase (see Tables 3.1, 3.8 and 3.9).
In Fig. 3.8 we show the wealth dynamics for the four trader populations
in both markets, for a simulation of 2000 steps. Both fundamentalists and
chartists account for 10% of total trader population. For the two markets,
3.3 Results 66

Table 3.8: Mean and standard error of volatility in market one. The results
are multiplied by 103 .

Chartist
Fundamentalist 0% 5% 10% 20%

0% 5.62 (0.58) 3.72 (0.50) 2.04 (0.25) 0.67 (0.08)

5% 8.15 (1.34) 4.20 (0.61) 1.89 (0.28) 0.79 (0.15)

10% 12.18 (1.87) 4.88 (0.79) 3.92 (0.71) 1.07 (0.19)

20% 37.22 (3.42) 19.38 (2.15) 7.49 (0.88) 2.25 (0.36)

Table 3.9: Mean and standard error of volatility in market two. The results
are multiplied by 103 .

Chartist
Fundamentalist 0% 5% 10% 20%

0% 4.90 (0.73) 3.87 (0.84) 1.95 (0.27) 0.67 (0.09)

5% 8.12 (1.53) 4.07 (0.66) 1.88 (0.29) 0.74 (0.09)

10% 7.99 (1.14) 5.08 (0.76) 2.26 (0.27) 1.01 (0.18)

20% 35.65 (3.22) 17.23 (1.87) 7.78 (1.02) 2.04 (0.48)

fundamentalists and contrarian traders tend to increase their wealth at the

expense of momentum traders and random traders. The dierences in wealth
are less pronounced for the single market, but we should recall that in this
case the number of traders rises to 4000, and they tend to trade ve times
less than for the single market.
3.3 Results 67

5
x 10
3.8
contrarian
fundamentalist
3.6 momentum
random

3.4

3.2
Wealth

2.8

2.6

2.4

2.2
0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time

Figure 3.8: Wealth dynamics of the four trader populations for a simulation of
2000 steps, for two markets.

Two markets: transaction tax in one

Here we discuss the dynamics of two markets, levying the tax in just one of
them (Market 1). When levying a tax on Market 1 transactions, we obviously
found total traders' wealth to decrease over time, because our market model
has limited resources. This decrease aects both cash  because the tax
is paid in cash  and prices  because a cash shortage aects prices. If
the fundamental price (pf ) is not adjusted according to the cash reduction,
in a closed market after a while fundamentalists wealth will also diminish,
because they tend to push prices towards their fundamental value which
eventually becomes unsustainable. They buy all the stocks they can and
then stay still, while the value of their stocks slowly diminishes. However, in
our simulations the cash drain of tax payment is negligible, because the tax
rate is low, the number of transactions made by each trader is also low, and
the number of simulated time steps is limited. Thus, the reported results
3.3 Results 68

are not aected by any cash drain.

Tables 3.10 and 3.11 give the mean and standard error of price volatility
in markets 1 and 2 respectively, computed for a tax rate of 0.1%, varying the
percentage of fundamentalists and chartists. Tables 3.12 and 3.13 show the
same congurations and data, this time computed for a tax rate of 0.5%.

Table 3.10: Mean and standard error of volatility in market one, with 0.1%
transaction tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 5% 10% 20%

0% 7.27 (0.99) 3.88 (0.59) 2.96 (0.48) 1.16 (0.17)

5% 5.88 (0.76) 4.38 (0.53) 2.23 (0.44) 1.36 (0.26)

10% 11.55 (1.26) 7.16 (1.02) 3.39 (0.52) 1.28 (0.17)

20% 43.12 (4.44) 16.71 (1.87) 10.86 (1.30) 2.71 (0.52)

Table 3.11: Mean and standard error of volatility in market two, with 0.1%
transaction tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 5% 10% 20%

0% 6.16 (0.81) 3.19 (0.47) 2.45 (0.43) 0.85 (0.08)

5% 5.77 (0.69) 3.89 (0.67) 2.80 (0.38) 0.68 (0.09)

10% 11.48 (1.83) 7.44 (1.05) 2.10 (0.31) 1.33 (0.24)

20% 36.92 (4.61) 17.62 (2.29) 7.05 (1.05) 1.56 (0.19)

The eects of the tax observed for a single market (no substantial dif-
ferences for random and fundamentalist traders alone, volatility increase in
the presence of chartists) are fully conrmed in the case of a tax levied on
3.3 Results 69

Table 3.12: Mean and standard error of volatility in market one, with 0.5%
transaction tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 5% 10% 20%

0% 6.76 (0.92) 5.06 (0.65) 3.14 (0.44) 2.05 (0.26)

5% 5.28 (0.67) 4.82 (0.93) 3.95 (0.73) 2.24 (0.28)

10% 11.09 (1.57) 6.61 (0.83) 5.77 (0.88) 3.81 (0.66)

20% 36.10 (3.64) 29.09 (2.48) 16.26 (1.69) 7.28 (0.72)

Table 3.13: Mean and standard error of volatility in market two, with 0.5%
transaction tax. The results are multiplied by 103 .

Chartist
Fundamentalist 0% 5% 10% 20%

0% 5.58 (0.61) 4.54 (0.79) 1.98 (0.29) 0.89 (0.15)

5% 6.98 (1.11) 3.52 (0.7) 1.91 (0.35) 0.72 (0.10)

10% 12.09 (1.84) 3.74 (0.60) 4.05 (0.74) 1.02 (0.24)

20% 43.63 (3.79) 18.06 (2.10) 5.92 (0.86) 1.10 (0.12)

one market, linked to a second, untaxed market. The increase in volatility

is however less pronounced, maybe because the market volatility is already
very high.
The most signicant eect we found is that the taxed market presents a
greater volatility than the linked untaxed market, in all those cases where
levying the tax has a major eect, i.e. in the presence of chartists. For a
highly speculative market, i.e. for the higher percentages of chartists, the
untaxed market shows a reduction in volatility with respect to the case of no
3.3 Results 70

tax market, while the taxed market shows a strong increase, thus adsorbing
to some extent additional volatility from the former.
Table 3.14 shows average daily trading volumes in both markets, for
dierent trader compositions and tax rates. The taxed market is, as always,
Market 1. The values are averaged over 20 simulations, and standard errors
are also given.
As expected, when no tax is levied, average trading volumes do not dier
signicantly from one market to the other. The introduction of the tax leads
to smaller volumes in the taxed market, in all those cases where it results in
a price volatility increase. The dierence in trading volumes is not as large
as the dierence in volatility, at the most in the order of 20%. This nding
conrms, however, that traders tend to shun the taxed market, and that a
lower volume triggers an increase in volatility, as discussed in Section 3.3.1.

Table 3.14: Average daily volumes. Tax levyed on market one only. The
results are divided by 103

Pop. (%) No Tax 0.1% Tax 0.5% Tax

F. C. Mkt1 Mkt2 Mkt1 Mkt2 Mkt1 Mkt2

0 0 9.49 (1.05) 9.48 (1.04) 9.55 (1.07) 9.46 (1.05) 9.47 (1.07) 9.57 (1.07)

0 10 9.97 (1.05) 10.01 (1.05) 9.81 (1.04) 9.91 (1.05) 9.37 (1.02) 9.85 (1.04)

0 20 10.55 (1.07) 10.63 (1.08) 10.13 (1.05) 10.54 (1.08) 9.26 (1.03) 10.31 (1.05)

10 0 8.61 (0.94) 8.60 (0.94) 8.56 (0.94) 8.61 (0.94) 8.57 (0.94) 8.68 (0.94)

10 10 9.24 (0.99) 9.29 (0.98) 9.05 (0.97) 9.25 (0.99) 8.51 (0.94) 9.25 (0.99)

10 20 10.01 (1.05) 9.95 (1.06) 9.44 (1.01) 9.99 (1.05) 8.40 (0.96) 9.96 (1.04)

20 0 7.91 (0.90) 7.87 (0.90) 7.85 (0.90) 7.89 (0.89) 7.82 (0.89) 7.91 (0.90)

20 10 8.50 (0.94) 8.47 (0.95) 8.30 (0.93) 8.50 (0.94) 7.78 (0.88) 8.58 (0.95)

20 20 9.17 (1.00) 9.12 (0.99) 8.76 (0.98) 9.21 (1.01) 7.77 (0.92) 9.27 (1.01)
Chapter 4

Short Selling and Margin

Trading

In this Chapter, we discuss the eects of introducing and removing short-

selling restrictions and margin requirements on a stock market. Our aim
was to study whether and how stock prices, volatility and long-run wealth
distribution are inuenced by these kinds of restrictions. The introduction
and the removal of constraints enabled us to analyse some interesting issues:
eects of restrictions on volatility, long-run agents' wealth distribution and
the relationship between price shocks and in debt positions.

4.1 Motivations

After the great stock market crash of 1929, some restrictions were imple-
mented to ensure the market does not crash again. On one hand, when
prices declined, many investors who had bought stocks on margin tried to
sell their shares disrupting the market. On the other hand, short sellers were
pointed out as one of the main causes of the crash. The U.S. stock market
reacted restricting short-selling and setting margin requirements.
4.1 Motivations 72

In 1934 the U.S. Congress gave the Federal Reserve Board the power to
set initial, maintenance and short sale margin requirements on stock markets.
Margin requirements were set in order to reduce excessive volatility of stock
prices, protect investors from losses due to speculative activities, and reduce
loans by banks to stockholders, moving credit toward more productive assets.
The 1987 stock market crash renewed both political and academic in-
terest on the eectiveness of restriction policies for stocks and derivative
products. Since then, a wide debate on these solutions started, and studies
were performed on the eects of such impositions.
In April 2005, the China Securities Regulatory Commission (CSRC) is-
sued a new plan for state share reform. As reported by Bloomberg News1 ,
China plans to allow investors to take out loans to buy shares and to sell
borrowed stock for the rst time, moves aimed at tapping the country's $4
trillion of bank deposits and boosting trading. The China Securities Regu-
latory Commission may select ve brokerages to start margin-lending and
short-selling services this year". This event will surely renew the interest on
short-selling and margin requirements regulations.
Buying on margin means to borrow money from a bank or a broker-
dealer to buy securities. The margin requirements set the maximum legal
amount that an investor may borrow to increase her purchasing power, so
she can buy securities without fully paying for them. For instance, if the
initial margin requirement is set at 20 percent, an investor can borrow up to
80 percent of the current value of the owned securities.
There has been an heated debate on the eectiveness of margin regula-
tions and on their inuence on asset prices. The central issue is the claim
that margin requirements have an inuence on stock price volatility.
1
For more details see http://www.bloomberg.com
4.1 Motivations 73

In late eighties, some studies by Hardouvelis (1988, 1990), claimed that

there is evidence of a negative relationship between stock volatility and mar-
gin requirements. Moreover, he asserted that changes in margins level can
inuence monthly stock return volatility. These conclusions support the
opinion that margin requirements could be used to control price volatility.
On the other hand, previous literature disagree with Hordouvelis' nd-
ings. Moore (1966) stated that margin requirements fail to full their objec-
tives. Largay and West (1973) and Ocer (1973) also concluded that changes
in margin requirements had little or no eect on stock price volatility.
Owing to the results of Hardouvelis, the debate on margin requirement
eectiveness has become very heated. Many authors, including Salinger
(1989), Ferris and Chance (1988), Schwert (1989) and Hsieh et al. (1990),
re-examined the connection between margin and volatility. These authors
examined the issue from dierent points of view using dierent econometric
techniques, but they uniformly concluded that there is no evidence of a rela-
tionship margin-volatility. Kim (2002) tested whether margin requirements
aect individual wealth-constrained speculators. To test this possibility, they
examined the stock market reaction to changes in the initial margin require-
ment of the Tokio Stock Exchange. The analysed the volatility of the stocks
with the highest percentage of individual ownership, but they found, nding
that changes in initial margin requirement don't have much eect on the
volatility of those securities.
Another critical question in nancial literature, that is fairly symmetri-
cal to margin trading is whether and how short-sale constraints aect the
tendency of the stock markets. Short selling is a technique used by investors
who try to prot from the falling price of a stock. They borrow the shares
from someone else and sell them. When the price falls, they will cover their
4.1 Motivations 74

position by buying back the shares. If their prediction was right, short sellers
gain a prot.
After the stock market crash of October 1929, many short-sale restric-
tions were imposed on short-selling in the United States. Short sellers were
immediately pointed out as the cause of the collapse, so three regulatory
changes were decided in order to reduce short-selling2 .
Short-selling advocates claim that it increases liquidity, favours risk shar-
ing and increases informational eciency. On the other hand, opponents of
short-selling claim that it causes high volatility, favors market crashes and
panic selling.
Miller (1977) observed that, if short-selling is restricted and investors
have heterogeneous beliefs, the observed price of a security does not reect
the beliefs of all potential investors, but only the opinion of the optimistic
ones. The implication of his idea was that stocks may be overpriced because
of short-selling restrictions. Miller's hypothesis implies a negative relation-
ship between short interest and returns. In recent years, empirical evidence
on this relationship has been pointed out by several studies, among them we
cite Jones and Lamont (2002), Ofek and Richardson (2001) and Chen et al.
(2002).
King et al. (1993) studied the eect of short selling on asset market bub-
bles in an experimental laboratory environment. found that short selling does
not inuence market bubbles. Ackert et al. (2002) conducted experiments on
two asset markets and stated that short selling eliminates the bubble-and-
crash phenomenon. Haruvy and Noussair (2006) studied the relationship
between short-selling constraints and assets prices using a simulation model
based on the work by De Long et al. (1990b). They found that short selling
2
See http://www.prudentbear.com/press_room_short_selling_history.html
4.2 The Extended Model 75

reduces prices to levels below fundamental values and that the reduction of
the bubble-and-crash phenomenon is the consequence of such a trend rather
than of the eectiveness of short selling restrictions.
Some studies examine the relationship between return volatility and
short-sale constraints. Ho (1996) produced evidence that volatility increased
when short-selling prohibition was lifted during the Pan Electric crisis of
1985. Kraus and Rubin (2003) developed a model to predict the eect of
index options introduction on volatility of stock returns. Since short-selling
the stock was restricted, the option was considered as a form of reduction of
this constraint. The model is highly stylized, and it predicts that volatility
can either increase or decrease, depending on model parameters.
Diamond and Verrecchia (1987) asserted that short-sale restrictions can
slow down the response of prices to new information: some investors who
want buy or sell cannot take part in the market bringing a decline in liquidity.
In other words, if short-selling is possible, there is greater liquidity.

4.2 The Extended Model

In this Section we introduce the major improvements to the model we de-

veloped in order to assess the impact of short selling restrictions and margin
requirements.
Both margins and short-selling restrictions are implemented in a simpli-
ed manner. We don't distinguish between initial margin requirements and
maintenance requirements. There are no transaction costs or taxes, so agents
can borrow money/stocks without paying any interest for them. Moreover,
margin and short-selling requirements are kept symmetrical, in the sense
that their maximum allowed percentages are the same.
The population of traders is made up of two main categories: the rst one
4.2 The Extended Model 76

consists of agents that can issue orders using their available limited resources.
They are forbidden to sell if they do not have any stock to sell, and they
cannot buy if they do not have enough money to do so. The second one is
made up of traders that are allowed to buy/sell stocks in debt. The agents
can sell stocks without owing them (we will say that they can issue in debt
selling orders ) and buy shares without owing enough money to pay them
(in debt buying orders ). We will name agents belonging to the second group
Debt Prone Trader (DP T ), and we will call agents from the rst group
non-Debt Prone Trader (non − DP T ). Both DP T and non − DP T belong
to one of the four categories of traders described in Chapter 3. For the sake
of brevity we will mark DP T traders with a star (for instance Random*
means Debt Prone Traders of type Random).
It is worth noting that in this case we slightly modied the strategy
of fundamentalist traders. We improved their model by transforming the
trading probability from a constant to a function depending on the current
price p(t) and on the fundamental price pf . At each time step, they decide
whether or not to trade with a probability p depending on the ratio between
pf and p(t). If p(t) = pf , the probability p will be equal to 0.0, and it will
p
increase as a squared function of the ratio max( p(t)
f
, p(t)
pf ). The maximum

value of p is set at 0.1. Note that, if the price of the asset is close to pf , the
trading activity of fundamentalists is low, because the market is not very
attractive for them.

4.2.1 non-Debt Prone Traders

non−DP T are risk-adverse agents, so they trade using their limited resources
without issuing in debt orders. If a non debt prone trader issues a buy (sell)
limit order, the order amount and the limit price are computed as described
4.2 The Extended Model 77

in Chapter 2. Note that here the parameter k is set at a value equal to 1.4.
This choice brings to smaller values of volatility in comparison with those
found in Chapter 3, but these values are still in agreement with those of real
nancial data.

4.2.2 Debt Prone Traders

DP T are risk-prone agents. They can borrow money (or stocks) without
paying any interest on it (there are no transaction costs or taxes), but in
debt transactions must be guaranteed by the agents' total wealth. The debt
level of each DP T cannot exceed a certain threshold called safety margin
(m). If a trader exceeds the safety margin she is forced to cover her position
and repay her debts. If an agent has negative wealth wi (t), she goes bankrupt
and is obliged to leave the market. The wealth wi (t) of the generic i − th
trader at time step t is dened as wi (t) = ci (t) + ai (t) · p(t), where ci (t) is
the amount of cash and ai (t) the amount of stocks that the agent holds at
time t. The safety margin is a constraint that can be moved up or down
in order to allow agents to borrow more or less money (stocks), setting the
debt limit. In our tests, the value of m varies from 0.0 to 0.9. If m = 0.0, it
means that both short selling and margin trading are forbidden. If m > 0.0,
it means that short selling and margin trading are allowed. For instance, if
m is set at the maximum value (0.9), it means that margins are set at 10%
and a debt prone trader can borrow stocks (to sell short) or cash (to buy on
margin) up to 90% of her cash (stock value). Each debt prone trader decides
whether to buy or sell rst on the basis of her strategy, then she has two
choices: to trade using her limited resources or to trade borrowing stocks or
money. These choices have equal probability.
If the i − th agent decides to issue an in debt order, the order size has
4.3 Results 78

an upper limit. If the agent issues a buy order, the amount of stocks to
purchase cannot exceed the quantity âbi (t) (see equation 4.1). In debt selling
orders are generated fairly symmetrically relative to in debt buying orders,
the maximum quantity on sale is âsi (t) (see equation 4.2).

ci (t)
âbi (t) = m · ai (t) + b c (4.1)
p(t)

ci (t)
âsi (t) = ai (t) + bm c (4.2)
p(t)
If an agent exceeds her safety margin, she is obliged to cover her position.
In particular, if she holds an amount of assets ai (t) < 0 and âsi (t) < 0, she
is forced to buy the amount of stocks equal to the quantity expressed in
equation 4.3. Symmetrically, if a trader holds an amount of cash ci (t) < 0
and âbi (t) < 0, she is forced to sell an amount of stocks equal to the quantity
expressed in equation 4.4.

ai (t) + m cp(t)
i (t)

abm = d− e (4.3)
1−m

ci (t)
m · ai (t) + p(t)
asm = d− e (4.4)
1−m

4.3 Results

First, we performed several computational experiments on a closed market,

i.e. a market with no cash or stock inow or outow. We performed several
tests varying some parameters of the model such as the percentage of DP T
and non − DP T agents, the percentage of the four population types, the
safety margin and the probability that DP T traders issue in debt orders. We
considered a large number of experimental cases, performing 20 runs for each
4.3 Results 79

case. Each simulation is usually run with 4000 time steps (corresponding to a
time span of 20 years) and with 400 agents. Then, we opened the market by
varying the cash of the traders, in order to understand how external shocks
inuence volatility, both with and without DP T s.

4.3.1 Closed Market

Random Traders

We rst explored market behaviour when only random traders are present.
We studied volatility trend varying some parameters of the model. Volatility
is dened as the standard deviation of prices in a time window 50 steps long.
We set the Safety Margin at 0.8 and varied the percentage of Random*
traders from 0% to 100% in steps of 25%. The results showed that an
increase in the percentage of random traders able to trade in debt brings a
very slight increase in volatility, as shown in gure 4.1.
We also explored return volatility varying the value of m parameter from
0.1 to 0.9. We observed that volatility looks not aected by m, but for
the highest values of m. This result does not depend on the percentage of
DP T s. In gure 4.2 we report this behaviour for simulations with 50% of
debt prone traders. When m = 0.9, there is an increase in volatility, but
this phenomenon is due to the bankrupt of some traders, which makes the
market unstable. When a trader goes bankrupt, she is forced to cover her
position as far as possible, and then she leaves the market. On one hand,
this fact implies that an amount of stocks are sold or bought at limit prices
low or high enough to have a high probability to be fullled, and on the other
hand it lowers the number of traders. Both eects tend to increase market
volatility.
We found similar results by varying the probability that DP T s issue
4.3 Results 80

−4
x 10

Volatility

2
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Fraction of Random*

Figure 4.1: Mean and standard deviation of price variance as a function of Ran-
dom*. The percentage of DPT was varied from 0% to 100% in steps of 25%, with
m = 0.8.
−4
x 10
5.5

4.5

4
Volatility

3.5

2.5

2
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Margin

Figure 4.2: Mean and standard deviation of price variance as a function of m.

in debt orders, as shown in gure 4.3. This behaviour is not unexpected,

because increasing this probability is equivalent to increase the percentage
4.3 Results 81

of in debt orders; with a high margin equal to 0.8, this yields many bankrupts,
with consequent volatility increase.
−3
x 10
6

4
Volatility

0
0.25 0.3 0.35 0.4 0.45 0.5 0.55 0.6 0.65 0.7 0.75 0.8 0.85 0.9 0.95 1
P(in debt order)

Figure 4.3: Mean and standard deviation of price variance as a function of P(in-
debt), with the percentage of DP T random traders set at 50% and m = 0.8.

We also studied the dynamics of wealth of the populations of traders.

We found that the wealth of both random and Random* traders remains
approximately the same during the whole simulation. Figure 4.4 shows the
P
average wealth 1/N i wi (t) of the two populations for a typical simulation
4000 steps long with 50% random and 50% Random* traders. The total
traders' wealth varies, depending on the stock price variations, but the wealth
of both populations does not dier signicantly for the whole simulation.

Trend Followers

Next, we investigated how volatility is inuenced by the presence of trend

followers (momentum and contrarian) debt prone traders. We performed six
groups of tests: Random and Momentum; Random and Momentum*; Ran-
4.3 Results 82

5
x 10
1.35
Random
Random*
1.3

1.25

1.2

1.15
Wealth

1.1

1.05

0.95

0.9

0.85
0 500 1000 1500 2000 2500 3000 3500 4000
Time

Figure 4.4: Dynamics of wealth of Random and Random* for a typical simulation
with m = 0.8 and P (in − debt) = 50%.

dom and Contrarian; Random and Contrarian*; Random, Momentum and

Contrarian; Random, Momentum* and Contrarian*. The total percentage
of trend followers has been set to 0, 10% and 20%. When there are both
momentum and contrarian traders, each kind accounts for one half of the
total percentage. Each value shown is the mean of 20 runs. The standard
deviation of market volatility in these runs is shown in parenthesis.
Table 4.1 reports the results for the various kinds of trend followers. First,
we found that the presence of a small percentage of momentum traders alone
(up to about 10 − 15%) does not tend to increase volatility, that increases
only for higher percentages. This is probably due to the limited amount of
traders' resources, and to the dierent time scales the momentum traders
use to compute the trend. This behaviour is similar with Momentum*, but
when they reach 20%, volatility sudden increases. This is due to a not
negligible number of traders who declare bankrupt, with consequent increase
in volatility.
4.3 Results 83

In the performed simulations, the presence of contrarian traders alone

tend to slightly increase volatility. This phenomenon is due to the hits
to the price in the opposite direction of the current price trend. This phe-
nomenon is not aected by limited traders' resources, because it is in ac-
cord with the intrinsic mean reversion behaviour of prices. The presence
of debt prone contrarian traders obviously increases this behaviour. When
debt prone contrarian traders reach 20%, there are very few bankrupts, that
further slightly increase volatility.
When both kinds of trend followers play together, the situation stabi-
lizes, irrespectively of their debt inclination. Market volatility tends to be
constant, and in this case we did not observe any bankrupt.

Table 4.1: Mean and standard error of volatility with trend followers and
random traders. The results are multiplied by 103 .

0% 10% 20%
Momentum 0.27 (0.04) 0.26 (0.04) 0.30 (0.04)

Momentum* 0.27 (0.04) 0.29 (0.04) 0.94 (0.41)

Contrarian 0.27 (0.04) 0.31 (0.04) 0.45 (0.06)

Contrarian* 0.27 (0.04) 0.35 (0.06) 0.59 (0.11)

Momentum and Contrarian 0.27 (0.04) 0.27 (0.02) 0.25 (0.03)

Momentum* and Contrarian* 0.27 (0.04) 0.28 (0.03) 0.27 (0.03)

We then analysed the eects of the dynamics of wealth with the trend
follower traders. We investigated if and how DP T agents inuence this
behaviour. We found that debt prone traders show the same dynamics
of non − DP T traders, but the eects are amplied. Contrarian* traders
gain more than Contrarian traders, Momentum* lose more than Momentum
traders, as shown in gure 4.5.
4.3 Results 84

5
x 10
1.6
Contrarian

1.5 Contrarian*

Momentum
1.4
Momentum*

Random
1.3

1.2
Wealth

1.1

0.9

0.8

0.7

0.6
0 500 1000 1500 2000 2500 3000 3500 4000
Time

Figure 4.5: Dynamics of wealth with trend followers for a typical simulation with
m = 0.8 and P (in − debt) = 50%.

Fundamentalists

When studying volatility behaviour using random traders and fundamental-

ist traders, we found that allowing fundamentalists to short sell and to buy
on margin volatility increases. Table 4.2 shows the market volatility (and
its standard deviation, related to 20 dierent runs), setting the total per-
centage of fundamentalists to 0, 10% and 20%. Note that no trader declares
bankrupt during all simulations. In all cases, the total wealth of both funda-
mentalists and debt prone fundamentalists tend to increase at the expenses
of random traders' wealth.
Figure 4.6 shows that volatility slightly increases with the increase of the
safety margin m and of the probability that debt prone traders issue a debt
order P (in − debt).
4.3 Results 85

Table 4.2: Mean and standard error of volatility with fundamentalists and
random traders. The results are multiplied by 103 .

0% 10% 20%
Fundamentalist 0.27 (0.04) 0.33 (0.04) 0.51 (0.10)

Fundamentalist* 0.27 (0.04) 0.36 (0.04) 0.55 (0.11)

−4 −4
x 10 x 10
4.2 4.8

4.6
4

4.4
3.8
4.2

3.6
4
Volatility
Volatility

3.4 3.8

3.6
3.2

3.4
3
3.2

2.8
3

2.6 2.8
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Margin P(in debt order)

(a) Volatility as a function of the (b) Volatility as a function of P(in-

Safety Margin. debt).

Figure 4.6: Volatility with a population made of 10% of DPT fundamentalists and
of 90% random traders.

All Kinds of Traders

In this section we report the results of tests we conducted using all trader
populations. The main goal was to understand whether or not the results
were merely the sum of the eects of each population.
First, we used momentum, contrarian and fundamentalist traders, setting
the same percentage of agents for each kind of strategy. We found that DP T
traders slightly increase volatility, as shown in table 4.3. In this table, the
reported percentages refer to each kind of traders. So, a percentage of 5%
means that there are 5% of fundamentalists, 5% of momentum and 5% of
contrarian traders.
4.3 Results 86

Table 4.3: Mean and standard error of volatility with fundamentalists trend
followers and random traders. The results are multiplied by 103 .

0% 5% 10%
Fundamentalist, Momentum, Contrarian 0.27 (0.04) 0.28 (0.04) 0.34 (0.06)

Fundamentalist*, Momentum*, Contrarian* 0.27 (0.04) 0.29 (0.04) 0.38 (0.07)

Note that the increase in volatility is not due to failures of traders, be-
cause no trader fails during any of these tests. The sensitivity analysis both
of the m parameter and of the probability that debt prone traders issue a
debt order show results similar to those presented in previous sections. The
ndings are shown in gure 4.7.
−4 −4
x 10 x 10
3.6 4

3.8
3.4

3.6
3.2

3.4
3
Volatility
Volatility

3.2

2.8
3

2.6
2.8

2.4
2.6

2.2 2.4
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Margin P(in debt order)

(a) Volatility as a function of the (b) Volatility as a function of P(in-

Safety Margin. debt).

Figure 4.7: Volatility with a population made of 5% of DPT fundamentalists, 5%

of DPT momentum and 5% of DPT contrarian traders.

Finally, we performed a group of tests using all kinds of traders, with

and without P DT . We set the percentage of both DP T and non − DP T
fundamentalist, momentum and contrarian traders at 5%, and the percentage
of both DP T and non − DP T random traders at 35%. We chose to equally
divide the thermal bath of agents of type random into 2 populations of the
4.3 Results 87

same size of DP T and non − DP T agents in order to avoid any kind of

asymmetry in the results. The resulting volatility was 0.31, with a standard
deviation of 0.04. This gure has to be compared with the case of a market
with no debt prone trader, but with the same percentage of fundamentalist,
momentum and contrarian traders with respect to random ones. In this
latter case, we had a volatility of 0.28, with a standard deviation of 0.04. In
both cases, there is no trader declaring bankrupt.
The sensitivity analysis referring to this case is shown in gure 4.8. Here
volatility looks to slowly decrease with m, except for the highest values. The
most interesting result is that, with all kinds of traders playing the market,
volatility clearly decreases with the probability that debt prone traders place
in debt orders. This result is due to the interplay of all kinds of traders, and
we don't have at the moment an explanation for it.
Figure 4.9 presents the wealth dynamics for a typical simulation in which
all eight populations are taken into account. Note that fundamentalists and
contrarians gain wealth, while momentum traders and, to a lesser extent, ran-
dom traders, lose wealth. This behaviour is due to the relationship between
the strategies of each type of trader and the mean reverting behaviour of the
market Raberto et al. (2003). The new nding is that debt prone traders
present the same behaviour of non − DP T , but they amplies the eects ob-
tained without them. Actually, fundamentalist and contrarian DP T s gain
more than fundamentalist and contrarian non − DP T s, while momentum
and random DP T s lose more than non − DP T s of the same kind.
4.3 Results 88

−4 −4
x 10 x 10
4 5

3.8
4.5

3.6

3.4

Volatility
Volatility

3.5
3.2

3 3

2.8
2.5

2.6

2
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Margin P(in debt order)

(a) Volatility as a function of the (b) Volatility as a function of P(in-

Safety Margin. debt).

Figure 4.8: Volatility with a population made of all types of traders, both DP T
and non − DP T .
5
x 10

2 Fundamentalist*

Fundamentalist

1.5
Contrarian*
Wealth

Contrarian

Random
1

Random*

Momentum

Momentum*
0.5
0 500 1000 1500 2000 2500 3000 3500 4000
Time

Figure 4.9: Dynamics of wealth with all eight types of traders for a typical simu-
lation with m = 0.8 and P (in − debt) = 50%.

4.3.2 Open Market

We opened the market by varying the cash of the traders. The main goal is to
understand how external shocks inuence volatility, both with and without
DP T s. The cash variation ∆ci (t) follows the law expressed in equation 4.5.
4.3 Results 89

∆ci (t) is proportional to each trader's wealth and its level depends on the σ
parameter.

∆ci (t) = wi (t) · [eN (0,σ) − 1] (4.5)

where N (0, σ) is a random draw from a Gaussian distribution with average 0

and standard deviation σ , and σ is a parameter. These inows and outows
of cash can be considered as external factors able to inuence the market.
We varied the amount of cash 10 steps apart, by adding to each trader's cash
the term ∆ci (t) dened in equation 4.5.
We performed many runs changing the population of traders. For the
sake of brevity, we report here just two examples: the rst one with random
traders and the second one with all kinds of traders. The ndings are similar
to those obtained using other combinations of traders.
The main result is that changes to traders' cash increase volatility. The
increase is patient both with and without DP T traders. Table 4.4 shows
this nding for tests conducted with non − DP T random traders and with a
population made up of 50% non − DP T and of 50% DP T random traders.
Note that if DP T s are present, volatility will increase more than without
them. Also, if the value of σ is too high, volatility will suddenly increase. We
studied the last case (reported in the last column of table 4.4) more deeply,
and we found that the excessive increment in volatility is due to a sudden
increase in the number of traders who fail.
The quantity of traders who declare bankrupt can be inferred from gure
4.10, which shows the total number of traders active in the market versus
simulation steps. An excessive cash inow can destabilize the market. Even if
DP T s are not present, a large number of agents can fail and leave the market,
because of negative cash inows. This phenomenon yields an increase in price
4.3 Results 90

returns and in volatility. Figure 4.10 shows the population size superimposed
on prices and the population size superimposed on logarithmic returns for a
simulation with random traders alone, and σ = 10−4 . These gure show a
correspondence between the steps where traders' failures happen, and daily
return variations, which look very high during these steps.

Table 4.4: Mean and standard error of Volatility with random traders. The
results are multiplied by 103

Population σ

Random Random* 0.0 10−5 10−4

100% 0% 0.27 (0.04) 0.29 (0.05) 1.99 (1.48)

50% 50% 0.27 (0.03) 0.29 (0.06) 6.19 (4.53)

Time
Time
0 500 1000 1500 2000 2500 3000 3500 4000
120 400 0 500 1000 1500 2000 2500 3000 3500 4000
0.2 400

110
0.15
395
395
100

0.1
90
390 390
80 0.05
Population Size

Population Size
Prices

Returns

70 385 0 385

60
−0.05
380 380
50
−0.1
40
375 375
−0.15
30

20 370 −0.2 370

0 500 1000 1500 2000 2500 3000 3500 4000 0 500 1000 1500 2000 2500 3000 3500 4000
Time Time

(a) Population size superimposed on (b) Population size superimposed on

prices. returns.

Figure 4.10: Daily time series for prices (a) and returns (b) with random traders
and σ = 10−4 . The dotted line represents the population size.

If DP T s are present, the number of agents who declare bankrupt in-

crease. Also, these traders tend to fail sooner. We calculated the number of
failed traders after the end of the simulations, and we found an average of
150.95 bankrupts in the case of random traders alone (with standard devi-
4.3 Results 91

ation 71.00). If random DP T s are taken into account, the average number
of traders who leave the market increase to 239.10 (with standard devia-
tion 107.78). Figure 4.11 shows the relationship between traders' bankrupts,
prices and returns. In order to remark that debt prone traders tend to fail
more than non − DP T s, gure 4.11 reports the population size of both ran-
dom and random* traders. Note that, if the number of failures is too high
(over 50%), the market will become unsteady. Moreover, in the case of open
market, the results are robust to changes in the values of the safety margin
and of P (in − debt).
We conducted further experiments using dierent traders' populations, as
the ones described in section 4.3.1. We found similar results to those obtained
with only random traders  cash inows and outows increase volatility, debt
prone traders tend to declare bankrupt more frequently than non − DP T s of
the same kind, simulations are robust to changes in m and in P (in − debt).
Time
Time
0 500 1000 1500 2000 2500 3000 3500 4000
200 200 0 500 1000 1500 2000 2500 3000 3500 4000
0.2 200
Random
Random* Random
180
0.15 Random*

160

0.1
140
150 150
120 0.05
Population Size

Population Size
Prices

Returns

100 0

80
−0.05
100 100
60
−0.1
40

−0.15
20

0 50 −0.2 50
0 500 1000 1500 2000 2500 3000 3500 4000 0 500 1000 1500 2000 2500 3000 3500 4000
Time Time

(a) Population size superimposed on (b) Population size superimposed on

prices. returns.

Figure 4.11: Daily time series for prices (a) and returns (b) with 50% non − DP T
and 50% DP T random traders, with σ = 10−4 . The dotted line represents the
population size.
Chapter 5

The Interplay Among Two

Stock Markets and the FOREX

It is well known that the recent nancial crises, starting from the Mexican
pesos crisis in 1994 to the Argentina's in 2001, have been accompanied by
episodes of nancial markets contagion, that is, many countries have expe-
rienced increases in the volatility and comovements of their nancial asset
markets.
Although changes in the statistical properties of prices are predictable
in countries experiencing nancial and exchange rate crises, the patterns of
comovement and of contagion of crises across countries are still not fully
understood. The denition itself of contagion, in fact, varies widely across
literature. A large number of tests have been proposed for assessing the
presence and the level of international contagion, but the results are often
conicting.
The main goal of this Chapter is to analyse the interaction between
two stock markets in two dierent countries, both during tranquil periods
and during a monetary crisis. We developed a multi-agent model with two
5.1 Contagion and interdependence 93

articial stock markets and two dierent currencies, by extending the general
framework described in previous chapters. The starting point of this study
was the development of a foreign exchange market (FOREX), that provides
a link between the two stock markets and sets the current exchange rate.

5.1 Contagion and interdependence

In recent years, much attention has been given to transmission of nancial

crises from a country to other countries, and usually this topic gains interest
after an international crisis.
Generally speaking, the spread of crises from one market to other mar-
kets depends on the links existing among those markets. One of the most
important issues is that there is still ambiguity on the denition and on the
meaning of the term contagion, and therefore a large number of method-
ologies and of tests have been proposed to measure it.
There are papers that attempt to detect and measure the factors that
favour nancial crises, such as those by Forbes (2004) and by Eichengreen
et al. (1996). Also, a number of papers use ARCH and GARCH techniques
to estimate how changes in volatility are transmitted across countries; see
for instance Hamao et al. (1990). However, is very dicult to identify the
channels through which contagion occurs, and to measure their weight. Many
researchers agree that the straightforward approach to test for contagion is
to analyse the cross-market correlation coecient. For example, Butler and
Joaquin (2002) analysed the correlation dynamics in bear, calm and bull
markets. They found an increase in correlations during bear market periods
compared with calm and bullish periods.
We embrace the terminology proposed by Forbes and Rigobon (2002):
they asserted that stock markets can exhibit a certain degree of comove-
5.2 The Extended Model 94

ments both before and after a shock or a crisis in one market. They dene
contagion as a signicant increase in cross-market linkages after a shock to
one country (or group of countries). This means that contagion occurs only
if cross-market comovements increase signicantly after a shock. On the
other hand, if the markets exhibit a high degree of comovement during peri-
ods of stability, even if the markets continue to be highly correlated after a
shock to one market, this may not constitute contagion. The authors use the
term interdependence to refer to this situation. Forbes and Rigobon test for
contagion by following a correlation analysis approach. According to their
denition, contagion occurs only if there is an increase in the unconditional
correlation coecient. They dene the unconditional correlation coecient
as the traditional correlation coecient adjusted in order to take into account
the bias in heteroscedasticity (see Forbes and Rigobon; 2002).

5.2 The Extended Model

We consider an economy with two stock markets (SM1 and SM2 ) and one
foreign exchange market (F OREX ). The two stock markets are perfectly
symmetric, except for the accepted trading currency: the stocks of the SM1
are exchanged using the dollar, while those of the SM2 market are ex-
changed using the euro. The F OREX determines the exchange rate be-
tween the dollar and the euro.
At each time step, each trader trades only within one market. Before
trading takes place, each trader, in accordance with an attraction function
based on expected gain may decide to leave a market, switching to the other
one. Note that the trader converts all her money into the currency of the
destination market before leaving the current market. This choice increases
the purchasing power of the trader in the just selected market.
5.2 The Extended Model 95

If a trader decides to buy or sell stocks, she places a limit order on the
selected stock market, as described in Chapter 3.
The FOREX market diers from the stock markets in two main respects:
the traders issue only market orders, and a market maker is assumed to
adjust the exchange rate at the end of each trading period, on the basis
of the excess demand, as described in Section 5.2.1. At the end of each
simulation step, the exchange orders are collected and the new exchange
rate is computed. The FOREX is a closed market, so the total amount
of cash cannot vary during the simulations. If all the exchange orders are
executed at the new exchange rate, the quantity of both dollars and euro
will change. In order to avoid this phenomenon, we randomly choose and
discard a number of orders, to equilibrate the amount of exchanged cash.
Also, in the case of the F OREX the agents issue market orders, whose
size is a random fraction of the current cash owned by the trader herself.
In particular, each market order has information about the currency to sell
(dollar or euro), the order amount, and the currency to buy (euro or dollars).
The order amount cannot exceed the trader's current cash availability, and
the amount of currency that the agent will achieve to buy depends on the
new exchange rate S(t + 1).

5.2.1 The exchange rate clearing mechanism

The exchange rate is adjusted with respect to excess demand ED(t). In

particular, the exchange rate S(t + 1) for the simulation step t + 1 is given
by equation 5.1:

S(t + 1) = S(t) · (1 + c · ED(t)) · er(t) , (5.1)

where c is a positive normalization coecient, and r(t) is a draw from a

5.2 The Extended Model 96

Gaussian Distribution N (0, σs (t)), whose standard deviation σs (t) depends

on the historical exchange rate standard deviation computed on a time win-
dow T , as shown in equation 5.2.

σs (t) = k ∗ σ(T ), (5.2)

where k is a positive coecient. The value of k is always equal to 1.4,

while the window T is 20 steps long.
The excess demand is the sum of the orders issued by the traders. More
specically, excess buying drives exchange rate up and, symmetrically, excess
selling drives exchange rate down.
Since that there are only two currencies, we decided that ED represents
the excess demand of euro against dollars. It follows that equation 5.1 is the
current exchange rate of the euro against the dollar.

5.2.2 The decision making process

We extended the four basic kinds of the agents' behaviour (random, fun-
damentalist, momentum and contrarian) by allowing them to issue market
orders in the FOREX. The only dierence between limit orders and market
orders is that market orders do not have a limit price, so they are executed
at the current price set by the market maker. Each kind of traders issues
market orders using exactly the same strategy used for issuing limit orders.
The extension is obvious, except for fundamentalists, which require further
explanation. Let be Sf the fundamental exchange rate /$ between the dol-
lar and the euro: if S(t) > Sf (S(t) < Sf ), the fundamentalist trader will
place a market order to sell (buy) euro in exchange for dollars.
5.3 Results 97

5.2.3 Attraction functions

At each simulation step, each trader chooses the most attractive stock market
by evaluating the attraction functions described in Chapter 3, but in this case
we decided to make some changes. First, not before ve simulation steps
from her last switching (corresponding roughly to one week of trading), each
agent chooses the market to trade in on the basis of her trading strategy.
This choice t better with the case of markets in dierent countries, and
allowed us to remove the constraint πji (t) ≥ 0.3. With regard to random
traders, we simplied their function and we decided that, when faced with
the possibility of operating in one of two markets, they randomly select one
of them. Finally, we decided to allow fundamentalists to switch market. This
choice was made in order to give them the possibility to leave the bearish
market in the case of a crisis. Let be pjf the fundamental price in market
j = 1, 2. The fundamental traders will choose the most protable market
on the basis of the dierence between the current price and the fundamental
price, as given by equation 5.3.

j
|pj (t)−p |
f
j
AF,i
p
j =e
f . (5.3)

The superscript F indicates the fundamentalist sub-population, j denotes

the j − th stock market, and pj (t) is the j − th stock price.

5.3 Results

Here we discuss the results of the computational experiments performed. We

analysed the markets behaviour in three steps. In Section 5.3.1 we present
the foreign exchange market only, while in Section 5.3.2 we discuss the dy-
namics of the three markets, rst without monetary shocks, and then simu-
5.3 Results 98

lating an inationary depreciation of the dollar.

5.3.1 Foreign Exchange Market

We rst tested the overall behaviour of the FOREX market model, vary-
ing the percentage of fundamentalists and of chartists, while xing the total
number of agents to 400. Note that chartists always comprise the same per-
centage of momentum and contrarian traders. Trader's initial endowment,
both in dollar and euro, was obtained by dividing agents into groups of 20
traders, and applying Zipf's law to each group, as described in Chapter 3.
Here, each agent is given an average amount of $50000 and 50000.
At the beginning of the simulations, the exchange rate between the two
currencies is set at the equilibrium value S(f ), which depends on the ratio
between the total number of dollars and of euro exchanged. Since the total
number of euro is exactly equal to the total number of dollars, both the
starting exchange rate and the fundamental value used by fundamentalists
are set at 1.0. The exchange rate series exhibit the usual stylized facts,
with fat tails of returns and volatility clustering. Figure 5.1 shows both the
daily euro-dollar exchange rate (top) and the daily time series of logarithmic
price returns (bottom) for a typical simulation 10000 steps long, having a
population composed of 10% fundamentalist, 5% momentum and 5% con-
trarian traders. Figure 5.2 shows the survival probability distribution of the
standardized logarithmic return (bold stars) superimposed on the best Gaus-
sian t (solid line). The deviation from Gaussian distribution shows again a
leptokurtic behaviour in the returns tail, with a very well dened power-law
behaviour for high values of returns.
The model is capable, to a certain extent, to reproduce the so called
disconnected puzzle (Obstfeld and Rogo; 2000) which states that the ex-
5.3 Results 99

change rate is usually far from its underlying fundamentals. In our model,
which is completely endogenous and thus characterized by the absence of
external news, the fundamental value of the exchange rate is equal to the
ratio between the total quantity of dollars and the total quantity of euro
owned by the traders, that is 1.0. Figure 5.1 show that the exchange rate
can substantially deviate from 1.0 for periods longer than 250 steps, that
correspond roughly to one year of trading.
1.3

1.2
Exchange Rate

1.1

0.9

0.8

0.7
0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000
Time

0.1

0.05
Returns

−0.05

−0.1
0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000
Time

Figure 5.1: Daily time series for euro-dollar exchange rate (top) and returns (bot-
tom).

5.3.2 Two stock markets and the FOREX: putting it all to-
gether

Here we discuss the dynamics of the two stock markets combined with the
foreign exchange market. We performed extensive simulations, 2000 time
steps long, and examined two dierent cases: the behaviour of the whole
economy without any external inuence, and the eects of a sudden depre-
ciation of the dollar.
Each simulation was run using 1200 agents divided into two separate
groups. The rst one was composed of traders acting only in the FOREX
market and had 400 agents. The role of this population is to keep the
5.3 Results 100

0
10

−1
10

ER > |Ret|
−2
10

−3
10

−4
10
−4 −3 −2 −1
10 10 10 10
|Ret|

Figure 5.2: Survival probability distribution of standardized logarithmic returns.

The bold stars represent an estimate of the cumulative distribution of returns related
to a simulation. The solid line represents the survival probability distribution of the
best Gaussian t.

F OREX alive independently of the two stock markets. The remaining 800
agents form the second group, which trade in the two stock markets following
the rules described in Section 5.2.2. It is worth noting that, on average, the
agents belonging to the second group are equally distributed between the
two stock markets, so all three markets have an average number of traders
equal to 400.
Traders' initial stock and currency endowment was obtained as described
in Chapter 3. Each trader assigned to SM1 is given an average $100000 and
1000 stocks, but no euro or stocks of SM2 . Symmetrically, each agent that
starts to trade in SM2 is given an average 100000 cash and 1000 SM2
stocks. Finally, the agents populating the F OREX is given an average
$100000 and 100000 cash, but they do not own any stock.
Both the starting price pj (0) of the stock j and the fundamental price pjf
√
known by the fundamentalists are equal to j/ 2j − 1 (Cj (0)/Aj (0)), where
Cj (0) is the total cash amount of market j , and Aj (0) is the total number
of shares of market j . The value is equal to $80 for SM1 , and 80 for SM2 .
5.3 Results 101

Similarly, at the beginning of the simulations the exchange rate /$ is set
at a value equal to the ratio between the total number of euro and dollars,
that is 1.0.
Figures from 5.3(a) to 5.5 show the results of a typical simulation 2000
steps long. The trader population is composed of 10% fundamentalists, 10%
momentum, 10% contrarian, and 70% random traders. In particular, gures
5.3(a) and 5.3(b) show the daily prices and daily log-returns for the SM1
stock and SM2 stock respectively. Figure 5.4 show the dynamics of the euro-
dollar exchange rate, and gure 5.5 shows the dynamics of traders' wealth.
All three markets of the model exhibit the key stylized facts of nancial
time series, and the dynamics of wealth distribution is unvaried, with fun-
damentalist and contrarian traders winning at the expenses of random and
momentum traders. The presence of the exchange market does not seem to
inuence by itself the other markets, either with and without the GARCH
eect.
110 110

100 100

90
Prices

Prices

90
80

80 70

60
70
50
0 200 400 600 800 1000 1200 1400 1600 1800 2000 0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time Time

0.15 0.15

0.1 0.1

0.05 0.05
Returns

Returns

0 0

−0.05 −0.05

−0.1 −0.1

0 200 400 600 800 1000 1200 1400 1600 1800 2000 0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time Time

(a) SM1 . (b) SM2 .

Figure 5.3: Daily time series for stock prices (top) and returns (bottom).
5.3 Results 102

1.5

Exchange Rates 1.4

1.3

1.2

1.1

0.9

0.8
0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time

0.1

0.05
Returns

−0.05

−0.1
0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time

Figure 5.4: Daily time series for euro-dollar exchange rate (top) and returns (bot-
tom).

5
x 10
2.8

2.7 contrarian
fundamentalist
2.6 momentum
random
2.5

2.4
Wealth

2.3

2.2

2.1

1.9

1.8

0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time

Figure 5.5: Wealth dynamics of the four trader populations.

5.3 Results 103

5.3.3 The inationary shock

We studied the consequences of a sudden nancial crisis of the dollar cur-

rency, due to exogenous factors aecting the dollar market. We modeled this
phenomenon by opening the market and increasing the wealth of traders in
dollars, simulating a depreciation of dollars against euro. In particular, at
the end of the rst half of the simulation after the step number 1000, we
doubled the amount of dollars owned by each trader.
Regarding price dynamics, the sudden increase of the quantity of dollars
lead to a slow increase in the fundamental value of the stock exchanged in
dollars, proportional to the quantity of money added. Figure 5.6(a) displays
the eect of the cash inow on the SM1 : the fundamental value of the stock
moves from $80.0 to $160.0. On the other hand the price of the SM2 stock
is not aected by the shock, as shown in Figure 5.6(b). Finally, Figure 5.7
points out the consequent appreciation of the euro against the dollar: the
euro doubles its value against the dollar currency.
Then we studied the consequences of the inationary shock on trading
volumes. We found an increase in volumes of the F OREX (see Figure 5.8),
that is due to the cash inow. The increase in the trading activity does not
spread to the stock markets, whose volumes remains substantially unvaried.
This behaviour was predictable, because the total number of stocks is kept
constants during all simulations, and a change in the total amount of cash
is not sucient to lead to a increase/decrease in the volumes.
There exists a set of stylized facts about the spreading of shocks across
markets. Corsetti et al. (2001) identied four empirical regularities charac-
terizing periods of nancial turmoil:

1. periods of nancial turmoil favour falls in stock prices;

2. volatility of prices increases during crisis periods;

5.3 Results 104

3. covariance between stock market returns increases during crisis periods;

4. returns correlation is not necessary larger than during tranquil periods.

Figure 5.7 shows that the dollar shock does not inuence the exchange
rate volatility. On the other hand, both the SM1 and SM2 price volatility
tend to increase in the days following the shock as presented in Figure 5.9(a)
and in Figure 5.9(b) respectively. We computed both weekly and monthly
volatility, but for the sake of brevity we report here only the latter. This
seems to conrm the second regularity quoted above.
We studied the dynamics of both returns and absolute returns corre-
lations between SM1 and SM2 during the tranquil period and during the
dollar crisis. Figure 5.10 shows the correlation analysis of a typical simulation
2000 steps long. The correlation coecients are calculated by considering
not overlapping return series 20 days long. Variables computed using weekly
and monthly returns gave very similar results. We found that the ination-
ary shock in not capable to inuence the correlation coecient dynamics,
which remain more or less the same during the whole of the simulation.
This conrms the fourth regularity quoted above.
On the basis of the denitions given in Section 5.1, we can conclude that
this model is not able to reproduce contagion, because there is no signicant
increment in the correlation values of returns. This result rules out the
possibility to run further tests on contagion, such as that discussed in a
series of papers by Boyer et al. (1997) and by Loretan and English (2000),
which require an increase in the correlation coecients as a necessary and
not sucient condition.
Finally we investigated the covariance dynamics of returns. Figure 5.11
shows that the shock brings to a sharp increase in the covariance of absolute
returns (bottom) and to a decrease in the covariance of raw returns (top).
5.3 Results 105

This result seems to conrm the third regularity identied in (Corsetti et al.;
2001).
180 100

160
90
140
Prices

Prices
120 80

100
70
80

60 60
0 200 400 600 800 1000 1200 1400 1600 1800 2000 0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time Time

0.2 0.2

0.1 0.1
Returns

Returns
0 0

−0.1 −0.1

−0.2 −0.2
0 200 400 600 800 1000 1200 1400 1600 1800 2000 0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time Time

(a) SM1 . (b) SM2 .

Figure 5.6: Daily time series for stock prices (top) and returns (bottom). The
inationary shock is applied at the end of the step number 1000.

2.5
Exchange Rate

1.5

0.5
0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time

0.1

0.05
Returns

−0.05

−0.1
0 200 400 600 800 1000 1200 1400 1600 1800 2000
Time

Figure 5.7: Daily time series for euro-dollar exchange rate (top) and returns (bot-
tom). The inationary shock is applied at the end of the step number 1000.
5.3 Results 106

Exchange Rate
3

2.5

1.5

0.5
0 200 400 600 800 1000 1200 1400 1600 1800 2000

6 Volumes
x 10
5

0
0 200 400 600 800 1000 1200 1400 1600 1800 2000

Figure 5.8: Daily time series for euro-dollar exchange rate (top) and volumes
(bottom). The inationary shock is applied at the end of the step number 1000.

−3 Dollar Stock −3 Euro Stock

x 10 x 10

7 7

6 6

5 5
Volatility

Volatility

4 4

3 3

2 2

1 1

0 0
500 600 700 800 900 1000 1100 1200 1300 1400 1500 500 600 700 800 900 1000 1100 1200 1300 1400 1500
Time Time

(a) SM1 . (b) SM2 .

Figure 5.9: Daily volatility for the stock prices between step 500 and 1500 of the
simulation. The inationary shock is applied at the end of the step number 1000.
5.3 Results 107

0.5

Ret. Correlation

−0.5
0 10 20 30 40 50 60 70 80 90 100
Time

0.5
|Ret| Correlation

−0.5
0 10 20 30 40 50 60 70 80 90 100
Time

Figure 5.10: Cross correlations of returns (top) and of absolute returns (bottom)
of the two stock price series. Each point in the horizontal axis represents one month
of trading, corresponding to 20 simulation steps.

−4
x 10
5

0
Ret. Covariance

−5

−10

−15

−20
0 10 20 30 40 50 60 70 80 90 100
Time

−4
x 10
5

4
|Ret| Covariance

−1
0 10 20 30 40 50 60 70 80 90 100
Time

Figure 5.11: Covariance of returns (top) and of absolute returns (bottom) of the
stock price series. Each point in the horizontal axis represents one month of trading,
corresponding to 20 simulation steps.
Chapter 6

Conclusions

This thesis presented an agent-based computer simulation framework for

building theoretical models in economics and nance. The project was built
on the basis of the Genoa Articial Stock Market, which was born in the
early 2000's at the University of Genoa. The original model has been com-
pletely re-engineered, and it has been improved and extended in order to
address a wide range of open problems in nance and economics. The cur-
rent version of the model includes many realistic trading features, and has
been validated by showing that the simulated time series exhibit the main
empirical properties of real nancial markets. This articial market has been
developed using object-oriented software techniques, and is aimed to be easily
extended and composed, yielding multi-asset and multi-market simulations.
This thesis faces three big open issues that the available literature do not
succeed in giving them an answer.
First, we studied the eects of transaction taxes in nancial markets. We
performed numerous simulations, varying trader composition and tax rate.
We found that levying a tax inuences market behaviour signicantly, even
when the rate is low. Price volatility increases consistently with tax rate,
 109

but only when chartist traders are present in the market. Then, we analysed
the dynamics of two markets, giving each trader the opportunity of choosing
the market she prefers to trade in, according to an attraction function. We
performed simulations on this market pair with no tax levied, and then taxing
one market. Firstly, we observed that, irrespective of trader composition
and tax rate, the interplay of markets leads to an increase in price volatility.
Secondly, we found that, notwithstanding the small transaction tax (typically
0.1-0.5% of transaction cost) and the simple trader models used, the tax
does actually impact heavily on market behaviour, increasing price volatility
and reducing trading volumes. This happens only with trader compositions
sensitive to the tax, namely those including chartist traders. Despite the low
tax rate, introducing the transaction tax increases price volatility, computed
for dierent time horizons, signicantly and reduces trading volumes, though
to a lesser extent. These results concur with many empirical ndings and
provide a measure, using a theoretical model, of the impact of a change in
market regulation. On the other hand, a part of the literature asserts that
speculators tend to leave the taxed markets, that thus become less volatile.
The second case study deals with the impact of margin requirements and
of short sale restrictions on stock markets. Considering the closed market,
we found that if short selling and margin trading are allowed, volatility will
tend to slightly increase. The increase in volatility is substantially unrelated
to restriction levels and to debt proneness of traders. We found that, if
short selling and margin trading are not banned, some traders could declare
bankrupt and leave the market. The number of bankrupts is usually very low
and negligible. Also, the wealth distribution of both DP T and of non−DP T
have the same trend, but for the rst ones the trend is stronger. We showed
that generally the open and the closed market have similar features, except
 110

for the fact that in an open market the number of bankrupts increases.
External factors, such as sudden variations of prices and wealth, damage
DP T s much more than non − DP T s, so DP T s tend to fail more easily
than non − DP T s. In general, bankrupts favor high volatility of prices and
may lead to periods of unsteadiness, so we can assert that in this sense the
presence of in debt positions may ease unsteadiness.
Finally, we presented a model made up of two stock markets with dier-
ent currencies, and of a FOREX market enabling traders to exchange their
currencies in order to switch to the other stock market. The markets are
completely closed and self-consistent. There is no external inuences, and
the amount of cash and stocks is kept constant, but for the case of controlled
cash inow simulating an inationary crisis. Simulating a monetary shock
in one market, with a steep, substantial inow of money, yielded a gradual
adaptation to the new fundamental prices in both the aected stock market,
and in the FOREX market, and showed, at least to some extent, three of the
four stylized facts about the spreading of shocks across markets identied
by Corsetti et al. (2001): volatility of prices and covariance between stock
market returns increase during crisis periods, and returns correlation is not
necessary larger than during tranquil periods. The fourth fact, i.e. that
periods of nancial turmoil favor falls in stock prices is not observed, but in
real markets it depends on traders' risk aversion, and on the ability of real
trader to move theirs assets to other investments. This is clearly not possible
in a closed model like this one, so the absence of this behaviour is obvious.
A similar consideration applies to contagion. We shoved that simply linking
two stock markets with an exchange market does not yield an increase in
return correlation when there is a crisis in one of the markets. Again, this is
not unexpected, because in real world contagion is a consequence of strong
 111

economic links between economies, and such links are simply not present in
our simple model. It needs to be said also that, while our model is able to get
insight on the intrinsic characteristics of linking two stock markets through
a FOREX market, showing that interesting behaviours arise simply from the
structural properties of the model, in reality FOREX markets are driven by
much more than stock markets' needs and by their internal traders. Much
more features have to be added to the model to reect more thoroughly how
real markets behave.
These three case studies show how the presented agent-based articial
market can be used to develop theoretical models in order to perform tests
and to validate hypotheses in economics and nance. A further extension
of the framework is in progress, and its goal is to analyse the impact of
stock option trading on the market of the underlying security. Although
the current version of the model is able to contribute to open debates which
attract public attention and arise the interest of policy makers, much more
features have to be added to the model to reect more thoroughly how real
markets behave. Among others, we may quote interest rates of bonds, stock
dividends, which could be related to the trend of the economy, also yielding
dierent fundamental values of the stock. Finally, traders' risk aversion has
to be modeled, which might aect the switching probability between markets
in the case of multi-market models. In future works, we plan to address all
these issues by extending the framework again.

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