Market Dynamics When Agents Anticipate Correlation Breakdown

The aim of this paper is to analyse the effect introduced in the dynamics of a financial market when agents anticipate the occurrence of a correlation breakdown. What emerges is that correlation breakdowns can act both as a consequence and as a triggering factor in the emergence of financial crises rational bubbles. We propose a market with two kinds of agents: speculators and rational investors. Rational agents use excess demand information to estimate the variance-covariance structure of assets returns, and their investment decisions are represented as a Markowitz optimal portfolio allocation. Speculators are uninformed agents and form their expectations by imitative behavior, depending on market excess demand. Several market equilibria result, depending on the prevalence of one of the two types of agents. Differing from previous results in the literature on the interaction between market dynamics and speculative behavior, rational agents can generate financial crises, even without the speculator contribution. Copyright © 2011 Paolo Falbo and Rosanna Grassi.