| Abstract: |
Behavioral finance has become an increasingly important subfield of finance.
However the main parts of behavioral finance, prospect theory included,
understand financial markets through individual investment behavior.
Behavioral finance thereby ignores any interaction between participants. We
introduce a socio-financial model that studies the impact of communication on
the pricing in financial markets. Considering the simplest possible case where
each market participant has either a positive (bullish) or negative (bearish)
sentiment with respect to the market, we model the evolution of the sentiment
in the population due to communication in subgroups of different sizes.
Nonlinear feedback effects between the market performance and changes in
sentiments are taking into account by assuming that the market performance is
dependent on changes in sentiments (e.g. a large sudden positive change in
bullishness would lead to more buying). The market performance in turn has an
impact on the sentiment through the transition probabilities to change an
opinion in a group of a given size. The idea is that if for example the market
has observed a recent downturn, it will be easier for even a bearish minority
to convince a bullish majority to change opinion compared to the case where
the meeting takes place in a bullish upturn of the market. Within the
framework of our proposed model, financial markets stylized facts such as
volatility clustering and extreme events may be perceived as arising due to
abrupt sentiment changes via ongoing communication of the market participants.
The model introduces a new volatility measure which is apt of capturing
volatility clustering and from maximum likelihood analysis we are able to
apply the model to real data and give additional long term insight into where
a market is heading. |