Abstract
A fundamental question that arises in derivative pricing is why investors trade in a particular derivative at a “fair” price supplied by Arbitrage Pricing Theory (APT). APT establishes a price that is fair for a disinterested investor with a particular set of beliefs about market evolution and attributes trading to differences in those beliefs entertained by the opposite sides of the transaction.
We present a model for an investor in a frictionless market that combines investors’ incentives in the form of pre-existing liability structures with derivatives pricing procedure tailored for a particular investor. This model enables us to show, through a series of experiments, that investors trade even when their belief structures are identical and accurate.
More generally, our study suggests that multi-agent simulation of a financial market can provide a mechanism for conducting experiments that shed light on fundamental properties of the market. As all processes in financial markets (including decision making) become automated, it becomes crucial to have a mechanism by which we can observe the patterns that emerge from a variety of possible investor behaviors. Our simulator, designed as a dealer’s market, provides such a mechanism within a certain range of models.
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King, A.J., Streltchenko, O. & Yesha, Y. Using multi-agent simulation to understand trading dynamics of a derivatives market. Ann Math Artif Intell 44, 233–253 (2005). https://doi.org/10.1007/s10472-005-4689-6
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DOI: https://doi.org/10.1007/s10472-005-4689-6