Excess Covariance and Dynamic Instability in a Multi-Asset Model

The presence of excess covariance in nancial price returns is an accepted empirical fact: the price dynamics of nancial assets tend to be more correlated than their fundamentals would justify. We propose an intertemporal equilibrium multi{assets model of nancial markets with an explicit and endogenous price dynamics. The market is driven by an exogenous stochastic process of dividend yields paid by the as- sets that we identify as market fundamentals. The model is rather flexible and allows for the coexistence of di erent trading strategies. The evolution of assets price and traders' wealth is described by a high-dimensional stochastic dynamical system. We identify the equi- libria of the model consistent with a baseline assumption of procedural rationality. We show that these equilibria are characterized by excess covariance in prices with respect to the dividend process. Moreover, we show that in equilibrium there is a positive expected marginal pro t in choosing more risky portfolios. As a consequence, the evolution- ary pressure generates a trend towards more remunerative strategies, which, in turn, increase the variance of prices and the dynamic insta- bility of the system.