QUANTITATIVE FINANCE RESEARCH CENTRE

Abstract

This paper contributes to the development of recent litera ture on the explanation power and calibration issue of heterogeneous asset pricing models by presenting a simple stochastic market fraction asset pricing model of two types of t raders (fundamentalists and trend followers) under a market maker scenario. It seeks to explai n aspects of financial market behaviour (such as market dominance, under and over-reaction, pr fitability and survivability) and to characterize various statistical properties (including a utocorrelation structure) of the stochastic model by using the the dynamics of the underlying determinis tic system, traders’ behaviour and market fractions. Statistical analysis based on Monte Carl o simulations shows that the long-run behaviour and convergence of the market prices, long (short )-run profitability of the fundamental (trend following) trading strategy, survivability of char tists, and various under and over-reaction autocorrelation patterns of returns can be characterized b y the stability and bifurcations of the underlying deterministic system. Our analysis underpins mec hanism on various market behaviour (such as under/over-reactions), market dominance and styl ized facts in high frequency financial markets. Date: Latest version: January 18, 2005.