Cross-section Instability in Financial Markets : Impatience, Extrapolation, and Switching

This paper presents a stylized model of interaction among boundedly rational heterogeneousagents in a multi-asset financial market to examine how agents' impatience, extrapolation, andswitching behaviours can affect cross-section market stability. Besides extrapolation and performance based switching between fundamental and extrapolative trading documented in single asset market, we show that a high degree of `impatience' of agents who are ready to switch to more pro table trading strategy in the short run provides a further cross-section destabilizing mechanism. Though the `fundamental' steady state values, which reflect the standard present-value of the dividends, represent an unbiased equilibrium market outcome in the long run (to a certain extent), the price deviation from the fundamental price in one asset can spill-over to other assets, resulting in cross section instability. Based on a (Neimark-Sacker) bifurcation analysis, we provide explicit conditions on how agents' impatience, extrapolation, and switching can destabilize the market and result in a variety of short and long-run patterns for the cross-section asset price dynamics