Note: [*] I am grateful to Jesper Riedler, Ingo Barens, Andreas Röthig, Philip Maymin and one anonymous referee for numerous helpful comments. Philip Savage contributed stylistic advice. Of course, all remaining errors are mine.
Abstract: This paper presents a Heterogeneous Agent Model of a financial market with chartist and fundamentalist traders that exhibit bounded rationality and short-term thinking to explain the effect of under and overreaction to news. The existence of the Market Maker’s finite price adjustment speed and the presence of risk aversion lead to the fact that prices do not adjust instantaneously to new information. Chartists use moving average rules to make their investment decisions. They can transform an underreaction-only scenario into a market with overreaction. The use of long moving average rules might even make the market unstable. Higher market efficiency (low deviations from fundamental value), on the other hand, is achieved if high rationality and long-term thinking for the agents is assumed.
Keywords: G14, D84, C62, C15
Keywords: Heterogeneous Agent Model, stock market, under and overreaction to news, moving average rules, financial stability