Bubbles and Crashes

Terence Yeo November 20, 2011

Introduction

Bubbles could be described as being commonly viewed as outbursts of irrationality: selfgenerating surges of optimism that pump up asset prices and misallocate investments and resources to such a great extent that a crash and major nancial and economic distress inevitably follows. (Gerber, 2000) As in any market, prices in nancial asset markets play an critical allocative role in the real economy. Asset prices provide important signals in the ecient allocation

of an economy's output, not only between current consumption and investment into future productive capacity, but also in the eective allocation of capital between dierent industries. Distorted prices would almost certainly lead to rms making inecient

investment decisions, and individuals making less than optimal consumption and saving decisions. Given the important role asset markets play in modern economies, it is

important to identify if and when distorted prices are likely to occur, what the patterns of distortion might result, and what consequences asset price distortions might have on the wider economy given their causes and dynamics. Two interconnected causes of bubbles are commonly cited in public discourse: speculation and irrationality. If 'good' investment involves the considered trade in assets for their expected long-term productive potential, then speculation is often described in terms of a reckless gamble, purchasing assets in the expectation (or hope) of a possible capital gain windfall over the short term, with longer term productive capacity associated with the assets being of marginal concern. While there is a ne line between

speculation and investment, in that it is often said that speculation is the name for a failed investment, and investment is the name for a successful speculation, the concept of speculation retains something of its original philosophical meaning: namely to reect or theorise without a rm factual basis. (Chancellor, 2000, p. xii) In other words, we often associate the idea of speculation as separate from investment, in the sense if investments involves rational forethought, speculative trades stems from some irrational basis.

This article attempts to review theoretical models how how asset market bubbles could possible arise. Section 2 reviews market settings in which participants act as if they were all rational and the limitations such market setting assumptions have on the possibility of asset market bubbles. Section 3 discusses the possibility that at least some market participants do not act in an entirely rational way and puts forth arguements for market models with boundedly rational participants. Section 4 concludes by discussing how

market models with boundedly rational participants might be modelled and suggests future lines of research.

Rational Bubbles

The denition of bubbles in economic literature echoes that of public sentiment. Brunnermeier (2008) denes bubbles as being associated with dramatic asset price increases followed by a collapse. Bubbles occur when the price exceeds the asset's

fundamental value, with the probable cause of such deviation being speculation, the trading behaviour in which investors hold the asset because they believe they can sell it at a higher price ... even though the asset's price exceeds its fundamental value. The fundamental value of an asset is simply the present value of all future cashows arising from the asset, with a discount rate consistent with the risk characteristics of the cashows. When future cashows are uncertain, the fundamental valuation of an asset is an expectation, conditioned on all relevant information available at that point in time. The conventional strand of nancial economics , often collected and labelled as the 'Ecient Market Hypothesis', asserts that asset market bubbles as prolonged and systematic deviations of asset prices from their ecient values, are unlikely if not impossible. In the text book scenario of ecient markets, it is considered that asset prices and returns [are] determined as the outcome of supply and demand in a competitive market, peopled by rational traders. These rational traders rapidly assimilate any information that is

relevant to the determination of asset prices or returns... and adjust prices accordingly. [...] If current and past information is immediately incorporated into current prices, then only new information or 'news' should cause changes in prices. Since news by denition is unforecastable, then price changes (or returns) are unforecastable... (Cuthbertson and Nitzsche, 2005, p. 54) Some 'ecient market' theorists might therefore argue that the occasional unforecasted dramatic swings in asset prices are instead attributable to unforeseen shocks to the underlying economy. Attempting to explain or describe these episodes as 'bubbles and

1 The

organisation of the eld of nancial economics into 'conventional' and 'behavioural' schools in The assignment of any

this review is nothing more than a useful rhetorical device employed by the author in order to tease apart, compare and contrast various possible views of asset market bubbles. papers to one or the other category does not assert that the authors of those papers cleave to that school, only that the ndings and arguments contained in those papers best support or illuminate certain aspects of a possible explanation or model of bubbles.

crashes' should not be seen as anything more than attempts at ex-post rationalisation of essentially random events. As Gerber (2000) puts it, the  [b]ubble is one of the most beautiful concepts in economics and nance in that it is a fuzzy word lled with import but lacking in a solid operational denition. Thus, one can make whatever one wants of it. The denition of

bubble

most

often used in economic research is that part of asset price movement that is unexplainable based on what we call fundamentals. [...] In the context of a particular model of asset price determination, if we have a serious misforecast of asset prices we might then say that there is a bubble. (p 4) Just as ancient man might attribute mysterious natural phenomena beyond the limits of his knowledge to capricious acts of gods, modern economists might attribute nancial phenomena unexplained by their models to market irrationality and the resulting bubbles. The true deviation in market bubbles might not so much be that of prices from what they should be, but of inadequate nancial models from economic reality. Under the Ecient Market Hypothesis, irrationality has no place in market outcomes. If all investors are rational, then by the denition of fundamental values as the 'rational' prices given all available information, there would be no possibility of market mispricing. Even if some investors are not rational, systematic asset mispricing should still not occur. Irrational investors are often modelled as noise traders: they independently make random mistakes, in so doing introducing uncorrelated noise into nancial markets. Since their deviations from rational trading behaviour are uncorrelated, they should have no systematic impact on market outcomes as their trades cancel each other out. In the situation where irrational traders make correlated mistakes, with the as-

sumption of complete markets, they create arbitrage opportunities for rational traders. By the process of arbitrage, prices would be brought back to fundamental values. Furthermore, since irrational traders make mistakes and allow rational traders to prot at their expense, irrational traders would eventually be driven out of nancial markets as their wealth diminishes over time. (Shleifer, 2000) The ecient market hypothesis ultimately depends on the presence of rational investors in nancial markets to guarantee that prices should, on average, equal fundamental values. However, models of rational bubbles show that even if every investor is rational, theoretically, bubbles might still occur as deviation of prices from fundamental values. Returns from asset investments comes from two sources, income through dividends and capital gains. Suppose in the current period, prices exceed the fundamental value of

the asset provided by present value of the dividends, with the dierence being termed the 'bubble component'; then even if all future dividends were expected to be constant, it would be possible for the prices to persistently exceed the present value of all future dividends if the bubble component in all future periods could be rationally expected to grow at a constant rate equal to the marginal investors' required rate of return. In this situation, capital gains due to growth in the bubble component in prices over time allows

expected returns from the bubble asset to be maintained at the investors' required rate of return, hence justifying the bubble in asset prices. Leroy (2011) provides a simple example of such a deterministic rational bubble. There is a strong relationship between rational bubbles and speculative trading behaviour. With the understanding of speculation as purchasing an asset with the intention of selling it in the near future for a capital gain, then as Harrison and Kreps (1978) put it, investors exhibit speculative behaviour if the right to resell a stock makes them willing to pay more for it than they would pay if obliged to hold it forever. If a rational investor is obliged to hold an asset forever, the only benets they derive from the asset if the stream of future dividends and they would never pay more than the fundamental value for the asset. However, if there is a possibility of resale with capital gains occurs, then the investors' indierence price would then be the expected present value of the resale price and the dividends collected in the interim. Therefore if the bubble is to

exist, there must be the possibility of future trade, and it is the speculative trading behaviour of investors which allows the bubble to persist. Deterministic rational bubbles however, do not seem to be a good explanation for the bubbles we think we observe in the real world. A rational bubble could be trivially ruled out if the required rate of return exceeds the growth rate of the aggregate economy, since the total value of the asset would eventually exceed aggregate wealth of all agents in the economy, making the expectation that prices grow at the required rate of return, irrational. (Brunnermeier, 2008) Furthermore, it might be argued that bubbles of this form, if not ruled out, should not distort investment and savings decisions in the real economy. Note that in such rational bubbles, the rate of return to the bubble asset

remains the risk appropriate required rate of return which is shared with the same asset in a non-bubble scenario. Since capital allocation decisions in the real economy is ultimately driven by dierential returns on investment on assets, should rates of returns remain the same with or without the bubble, investment decisions should be unaected by the presence of the bubble. Moreover, such deterministic rational bubbles never

burst, whereas it is the dynamics of ination and collapse which captivates attention on market bubbles in reality. This last point might be circumvented by stochastic bubbles, two examples of which was provided by Blanchard and Watson (1982). With stochastic rational bubbles, the bubble component, the deviation of prices from fundamental values, has a exogeneously given and positive probability of collapsing to zero in every period. However, so long as the return on the bubble asset is suciently above the required rate of return to compensate for the risk of the bubble bursting, prices remain above fundamental values. However, as Diba and Grossman (1987) point out, whilst rational bubbles could persist, they cannot emerge independently in a model.  [I]f a rational bubble exists at present, then it must have started at date zero, the rst date of trading of the stock. In other words, if a rational bubble does not exist at date

t, t 0,

then a rational bubble

cannot get started at... any subsequent date. This result applies to most models of the

'normal' deterministic kind, as well as all possible types of stochastic bubbles.(Kompas and Spotton, 1989) Finally Tirole (1982) showed that when traders have rational expectations, and have common priors on value of the asset, rational price bubbles are ruled out, even if traders are asymmetrically informed. Rational bubbles do not explain very well the kind of real world asset price ination and collapse we term as bubbles. Deterministic rational bubbles fail precisely because they are deterministic and perpetually growing, in the unlikely event that real world market conditions match the limited set of conditions in which they are not ruled out. Stochastic rational bubbles are ruled out, because under the necessary assumption of rationality of all participants, they cannot arise unless they have existed since the very rst day of trade. There is one further, less formal but more intuitive argument against rational bubbles: all rational bubbles require that the existence of the bubble is common knowledge in all periods of trade, and it is the common knowledge of the bubble which allows speculative trade to occur, and hence allowing the bubble to persist. Yet, in the real world, when asset prices enjoy a sustained period of growth, it would be faintly absurb to suppose that there exists a consensus amongst market participants that the increase in prices is due entirely to a bubble, and that high growth in prices are sustainable and bubble asset holdings are justiable simply because the bubble exists.

The Behavioural Critique

The Ecient Markets outcome, that prices in nancial asset markets is set as-if all market participants are rational, seems in general, to be decient in providing explanations of how nancial markets function in general, and particularly for our purposes of understanding market bubbles and crashes, how markets dysfunction. As detailed in the preceding section, models of rational bubbles not seem to provide a realistic framework with which to examine 'real world' nancial market crisises. Furthermore, there are several strands of argument which suggests that prices need not be ecient, and irrational traders would have systematic inuence on market outcomes.

3.1 Eectiveness of arbitrage

One key assumption of the Ecient Market Hypothesis is that information is free. Which market trader is the rst to recieve new information might be randomly determined, or new information might be common knowledge, but regardless, agents incur no costs in gaining new information. However, information costs are often non-trivial. Grossman and Stiglitz (1980) argued that in the presence of costly information, markets cannot

be completely informationally ecient, that prices need not be the same as their economic fundamental value. If prices were to always equal their fundamental value such that they perfectly reveal all relevant information, then all nancial transactions would have zero expected net present value and no trader can extract informational rents. If superior information does not provide additional prots, then no trader would seek new information if new information is costly. But if no trader seeks new information, then prices cannot possibly reect all relevant information and therefore would not equal their economic fundamental value. In the presence of irrational traders, arbitrage by rational investors in the face of temporary mispricings caused by irrational traders is the key argument for ecient markets. Another strand of argument against the Ecient Market Hypothesis is based on the limited eectiveness of arbitrage by rational traders. Arbitrage often involve short-selling, particularly in the case of bubbles. Substantial market regulations regarding short sales exists, and transaction costs associated with short selling can be signicant. Facing

prices which exceeds economic fundamental values, rational traders would only engage in arbitrage only if the deviation exceeds the transaction costs of arbitrage. Arbitrage as a riskfree trading strategy is dependent on the existence of complete markets, markets in which any contingent claim could be replicated. But in reality, markets are likely to be incomplete and there does not exist truly risk-free arbitrage positions, in which case fundamental risk is a signicant factor in risk-averse rational investors' decisions to trade against irrational traders. In the event that stock prices are noisy due to volatility in fundamental determinants of value, risk-averse rational traders reduce their stock holdings which in turn limits their inuence on stock prices towards fundamental values, in which case noise traders gain greater inuence over stock prices. (Campbell and Kyle, 1993) Furthermore, even with complete markets, De Long et al. (1990) argue that arbitrageurs are exposed to noise trader risk. Irrational noise traders might hold persistent optimistic or pessimistic beliefs while rational investors might have often have short time horizons, particularly if a large proportion of rational investors in a nancial market are institutional investors. The performance of institutional investors (or their managers) are often measured against aggregate market performance on a regular basis. A potential rational arbitrageur needs to bear in mind the potential for optimistic noise traders to hold even more optimistic beliefs tomorrow driving prices even higher. This could potentially lower the unrealised returns on his arbitrage position, whilst at the same time increase apparent market performance, worsening his relative performance in the short term. An important reason why arbitrage is limited is that movements in investor sentiment are in part unpredictable, and therefore arbitrageurs betting against mispricing run the risk, at least in the short run, that investor sentiment becomes more extreme and prices move even further away from fundamental value. [...] When arbitrageurs are

risk-averse, leveraged, or manage other people's money and run the risk of losing funds

under management when performance is poor, the risk of deepening mispricing reduces the size of the positions they take. Hence arbitrage fails to eliminate the mispricing

completely... (Barberis, Shleifer and Vishny, 1998) To quote Keynes, the market can stay irrational longer than you can stay solvent. The key forces by which markets are supposed to attain eciency, such as arbitrage, are likely to be much weaker and more limited than the ecient markets theorists have supposed. [...] [B]ehavioural nance has emerged as an alternative view of nancial

markets. In this view, economic theory does not lead us to expect nancial markets to be ecient. Rather, systematic and signicant deviations from eciency are expected to persist for long periods of time. (Shleifer, 2000) If irrational traders could have

systematic inuence on asset prices, it should be fruitful to examine how markets can be impacted by the presence of irrational traders.

3.2 Agent Rationality

Traditional economic theory postulates an "economic man," who, in the course of being "economic" is also "rational." This man is assumed to have knowledge of the relevant aspects of his environment which, if not absolutely complete, is at least impressively clear and voluminous. He is assumed also to have a well-organized and stable system of preferences, and a skill in computation that enables him to calculate, for the alternative courses of action that are available to him, which of these will permit him to reach the highest attainable point on his preference scale. (Simon, 1955)

Rationality of agents is a common assumption across all areas of economics. The denition of agent rationality is typically unproblematic. Given a utility function representing his preferences over various possible outcomes, and facing budgetary and other market constraints, a rational agent forms beliefs consistent with all available information, and given his beliefs, solves the constrained utility maximisation problem, and acts to implement the utility maximising solution so as to achieve an optimal outcome for himself, given his circumstances. There is no question that it would be rational for people behave rationally. However, economics is not only about how people should ideally behave. If economics is a science, then economic theory also needs to describe how economic systems work in real life; in particular, how people make decisions in their day-to-day lives when faced with intellectual and psychological constraints, and not only the economically conventional material and infrastructural constraints. Before assuming that all economic agents behave rationally, it must be asked: rational' manner described above. As Kahneman and Tversky (1979) wrote,  [r]ationality as a prescriptive advice for individuals with uncertain choices is trivially uncontroversial. But rational behaviour as

could

and

do

people behave in the 'hyper-

a description of how people in nancial markets behave is an empirical matter, and it seems to fail the test of reality. In arguing for the use of boundedly rational agents in economic modelling, Conlisk (1996) provided a list of possible arguments a 'conventional' economist might use to justify the assumption of 'unboundedly' rational economic agents. The list could be

summarised into four main categories: The rst is that the assumption of rational agents imposes intellectual discipline on economic hypotheses. The second is that optimal

behaviour should be obvious in most circumstances. The third is that even if optimal behaviour is not obvious, people's behaviour converges to the behaviour of unboundedly rational agents, as most people learn rational behaviour through practice, and people who do not learn to behave optimally do not survive. Fourth and denitely not least, the assumption of rationality permits mathematical tractability on analytical theories proposed to explain economic behaviour. The rst argument seems to stem partially from the fear that irrational behaviour is inexplicable behaviour. Rationality imposes strong constraints on the possible behaviour of individuals. Given a set of parameters and a utility function, it would be easy to

predict the behaviour of a rational individual and it would be easy to verify that a predicted behaviour is indeed justied by the set of circumstances the individual is hypothesised to be in. Without the constraint of rationality, it might be feared that any outcome can be predicted by the use of cunning choices of what irrationality implies in terms of agent behaviour, such that supposedly objective explanations of economic phenomena becomes nothing more than exercises in tautology. However, assumptions of boundedly rational behaviour need not be unconstrained. If systematic deviations away from rationality in decision making can be empirically established, then reasonable assumptions of how boundedly rational individuals behave could be rooted in empirical reality. Conlisk presented a formidable list of psychological biases found in experimental settings

2 and wrote: in such experiments, the mental tasks... are

often simple, at least relative to many economic decisions; whereas their responses are frequently way o. Most important, reasoning errors are typically systematic. There exists a substantial pool of empirical data in which to ground assumptions of boundedly rational behaviour. Lo (2004) also provides a very readable introduction to psychological biases commonly encountered in decision making with uncertain outcomes.

2 There

a mountain of experiments in which people: display intransitivity; misunderstand statistical

independence; mistake random data for patterned data and vice versa; fail to appreciate law of large number eects; fail to recognize statistical dominance; make errors in updating probabilities on the basis of new information; understate the signicance of given sample sizes; fail to understand covariation for even the simplest 2X2 contingency tables; make false inferences about causality; ignore relevant information; use irrelevant information (as in sunk cost fallacies); exaggerate the importance of vivid over pallid evidence; exaggerate the importance of fallible predictors; exaggerate the ex ante probability of a random event which has already occurred; display overcondence in judgment relative to evidence; exaggerate conrming over disconrming evidence relative to initial beliefs; give answers that are highly sensitive to logically irrelevant changes in questions; do redundant and ambiguous tests to conrm an hypothesis at the expense of decisive tests to disconrm; make frequent errors in deductive reasoning tasks such as syllogisms; place higher value on an opportunity if an experimenter rigs it to be the "status quo" opportunity; fail to discount the future consistently; fail to adjust repeated choices to accommodate intertemporal connections; and more. (Conlisk, 1996, p. 670)

Kahneman (2003) provides a recent review of models of boundedly rational behaviour in which a section bears repeating here:  [e]conomists often criticize psychological research... for its failure to oer a coherent alternative to the rational-agent model. This complaint is only partly justied: psychological theories of intuitive thinking cannot

match the elegance and precision of formal normative models of belief and choice, but this is just another way of saying that rational models are psychologically unrealistic. Furthermore, the alternative to simple and precise models is not chaos. Psychology offers integrative concepts and mid-level generalizations, which gain credibility from their ability to explain ostensibly dierent phenomena in diverse domains. In reply to the charge that most rational behaviour is 'obvious', Conlisk noted that information costs and deliberation costs are often none trivial. Heuristics are often used in human decision making specically because decision making is time-consuming and dicult, and heuristics when applied in the appropriate decision making context are ecient. For a boundedly rational individual, heuristics often provide an adequate

solution cheaply whereas more elaborate approaches would be unduly expensive. (ibid.) Psychological biases arise from the use of pyschological heuristics, mental rules of thumb in decision making, misapplied in inappropriate contexts. Individuals develop heuristics [by experience through trial and error] to solve various economic challenges, and so long as those challenges remain stable, the heuristics will eventually yield approximately optimal solutions to them. [...] If on the other hand, the environment changes, then it should come as no surprise that the heuristics of the old environment are not necessarily suited to the new. (Lo, 2004) What seems to be the obvious action to take in one context, would often turn out to be maladaptive in another. Finally, the third argument could be decomposed into two parts, that convergence argument that individuals eventually learn optimal behaviour, and the evolutionary argument that only rationally optimising individuals survive in the long run. If heuristics play a large role in human decision making, and if heuristics are learnt and adapted through trial and error, and directed by positive or negative reinforcement, it does seem as if individuals' heuristics and hence behaviour would eventually converge to optimality. However, Conlisk noted that  [l]earning is promoted by favorable conditions such as rewards, repeated opportunities for practice, small deliberation cost at each repetition, good feedback, unchanging circumstances, and a simple context. Conversely, learning is hindered or blocked by the opposite conditions. Financial markets might not provide such favorable conditions. For example, supposing that market bubbles do exist, a naive investor might be well rewarded for reckless speculation when markets surge, and 'learn' that speculative trading is optimal for maximising his wealth. When markets collapse, the same investor might not attribute his losses to his own trading behaviour, but instead to market wide and hence 'exogenous' circumstances. Learning, at least in the short

run, might deepen and not eradicate maladaptive behaviour especially if the lag between action and consequences is long. Even if convergence to rational behaviour does occur, the dynamics of the path of convergence could matter, especially if market conditions

regularly change. Then, the 'equilibrium point' of rational behaviour to which individual heuristics adapt towards, shift constantly, and heuristics never settle at some optimising point. The evolutionary argument that only rationally optimising individuals survive in the long-run need not hold. In the context of nancial markets, it is not the case that the only market participants are the ones who survived previous rounds of trading. In the context of the real world, as young workers enter the workforce and starting saving and investing towards their retirement, there should be a constant inow of new investors into markets some of whom might not behave in a fully rational way. As older workers reach retirement age, they start liquidating their asset holdings to fund their retirement, and there should be an outow of existing investors, some of whom could be unboundedly rational. At equilibrium, even if rational participants are more likely to survive multiple rounds of trade, there would always be a non-zero proportion of boundedly rational participants on the basis of exogeneously determined through-ow alone. Furthermore, it may not be the case that rational investors do better than boundedly rational investors with biased beliefs and trading strategies under all circumstances. Viewing nancial markets as evolutionary systems in which participants interact strategically, then, in biological terms, the key insight of evolutionary game theory is that many behaviors involve the interaction of multiple organisms in a population, and the success of any one of these organisms depends on how its behavior interacts with that of others. So the tness of an individual organism can't be measured in isolation; rather it has to be evaluated in the context of the full population in which it lives. (Easley and Kleinberg, 2010, p. 209) If we describe rational behaviour in the 'conventional' game-theoretic sense of an optimal behaviour given the utility maximising behaviour of rational opponents, then it could be that rational behaviour might not be fully optimal when at least some other market participants are not rational.

Modelling Irrationality

There is one argument that has yet to be replied is that of mathematical tractability of models of markets in which both rational and boundedly rational agents interact. In many models involving only rational agents, market equilibria could usually be dened in terms of xed points with respect to the optimal response functions of the rational agents given the responses of other agents. Given that all agents are symmetrical in the sense that they are all rational, this eases proofs of existence of equilibria ,and makes the derivation of the properties of equilibria relatively simple exercises in linear algebra. However as Friedman (2001) noted  [e]quilibrium models do not tell us when or how equilibrium might be achieved because they ignore the adaptation process in which traders respond in real time to cues generated by other traders. The adaptation process

10

allows traders to make big prots and losses, and it may lead to equilibrium quickly or slowly or not at all. It deserves careful study. But if market participants are allowed to be of dierent types, some rational and others not, with the boundly rational participants exhibiting dierent types of psychological biases, all of whom are constantly learning optimising behaviour, then it might be the case that market outcomes and processes might be dicult to characterise mathematically. As hinted at in the last section, one way of restoring mathematical tractability to such models might be the use of evolutionary game theory. Lo (2004) provides some background to the application of evolutionary ideas to analysis of nancial markets, and Friedman (2001) provides a more technical overview of how to approach analysis of nancial markets using evolutionary game theory models. Blume and Easley (1992) provides an example of an evolutionary game theory model in which rational traders interacts with less than rational traders, and found that the argument that wealth dynamics justify rationality is somewhat wanting, though in their model, irrational traders usually disappear from the market in the long-run equilibrium. Hirshleifer and Luo (2001) provides on the other hand, provides an evolutionary game theory model in which over-condent traders, agents who overestimate the signicance of their private information, persists in the long-run equilibrium despite the presence of fully rational agents. There are several attractive features of evolutionary game theory which makes its application to models of nancial markets with boundedly rational agents. First of all, the mathematical and theoretical properties of evolutionary game theory is well established, having been used in mainstream biology and mathematics since the early seventies. Secondly, evolutionary games have very intuitive interpretations in nancial markets. The unit of selection in nancial markets in evolutionary game terms are specic forms of trading behaviour. More protable trading strategies obviously increase the wealth of agents using them, hence more funds are directed by these 'tter' strategies in the following rounds. This corresponds nicely with the replicator system in evolutionary

games in which tter 'organisms' (or replicators) replicate themselves at a higher rate and hence increase their relative proportions in the overall population in the subsequent rounds. Next, in evolutionary games, the tness of a behaviour or strategy is not measured in isolation, but with respect to the relative proportion of various strategies within the market. This jibs well with the intuition that the success of any particular trading

strategy depends on whom it is played against, and allows for possible scenarios where rational agents might be swept away by waves of irrationality. Evolutionary games also allows for implementations of agent learning without having to explicitly dene how agents learn. For example, it might simply be assumed that agents have a positive

probability of using another strategy which outperformed their own. Also, evolutionary games do not require nor necessarily provide static equilibrium so-

11

lutions. The outcomes of evolutionary games is a process of change over time in the frequency distribution of replicators (Gintis, 2009). The population (and possibly market) dynamics over time is the key feature of concentration in evolutionary games, which is consistent with the ultimate aim of understanding how market prices might violently uctuate over time in response to Gerber's outbursts of irrationality. Evolutionary

games also allow introduction of random 'mutations', novel strategies exogeneously introduced to the overall population over time, corresponding with the exogeneously through-ow of market participants described in the last section. Amongst all of the many other attractive features, the one most appropriate to modelling markets with boundedly rational agents is the fact that evolutionary, as opposed to 'conventional' game theory is that agents need not be assumed to be rational, nor, unsurprisingly given its biological antecedents, that agents need to be conscious beings at all.  [T]he notion of evolutionary game theory... shows that the basic ideas of game theory can be applied even to situations in which no individual is overtly reasoning, or even making explicit decisions. Rather, game-theoretic analysis will be applied to

settings in which individuals can exhibit dierent forms of behavior (including those that may not be the result of conscious choices), and we will consider which forms of behavior have the ability to persist in the population, and which forms of behavior have a tendency to be driven out by others. (Easley and Kleinberg, 2010, p. 209) Another interesting perspective to take might be that of inductive game theory, recently proposed in Kaneko and Kline (2008). New investors into nancial markets often have limited understanding of how the 'game' is played. Inductive game theory attempts to formalise the process by which a player might use his experiences to form a hypothesis about the rules and structure of the game utilising experiences gained while (imperfectly) playing the game. Insights into investor learning might be gleaned through this line of research. At this point, this literature review is obviously unnished as a review of how asset market bubbles and crashes might be theoretically generated. However, it does appear further research along the lines of evolutionary game theory and perhaps inductive game theory might be fruitful and the author hopes to proceed alone those lines of inquiry.

12

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