Misspecified Fear or Model Choice? Evidence from Financial Markets
A new study reveals that traders in financial markets often switch between accurate and flawed models, not due to irrationality but from a rational drive for short-term profit, called greed-driven model choice. This collective behavior leads to persistent market anomalies like volatility smiles and return predictability. Using real option price data and a dynamic binomial tree model, the authors show that belief distortions and welfare losses can arise from rational incentives, not just psychological biases.
What it examines
This paper develops a dynamic model showing how traders in financial markets may switch between correct and incorrect models based on short-term profit incentives. Using option price data and binomial tree methods, it explains how such behavior leads to belief distortions, volatility smiles, and risk premia anomalies.
What it concludes
The study finds that belief distortions from greed-driven model switching cause significant welfare losses and mispricing in financial markets. These insights can help improve risk management, option pricing, and market regulation. Future research could extend the model to other asset classes and explore effects on market stability.
Evidence objects
Traders in financial markets often switch between correct and incorrect models, not due to irrationality, but from a rational, profit-driven urge termed 'greed-driven model choice,' fueling persistent belief distortions.
key_findings bullet 1 · key_findings · validation V0
Even rational traders, chasing short-term gains, can collectively create market anomalies like volatility smiles, return predictability, and pricing kernel distortionschallenging the idea that only psychological biases drive inefficiencies.
key_findings bullet 2 · key_findings · validation V0
Using a dynamic binomial tree model and real option price data, the study quantifies how greed and fear impact risk premia and welfare, but notes its focus on options may oversimplify broader market complexities.
key_findings bullet 3 · key_findings · validation V0
This paper introduces a novel, greed-driven endogenous model switching mechanism in derivative and volatility modeling, where rational traders deviate from correct models for short-term gains. This unique approach quantitatively links incentive-driven model choice to key market anomalies, offering fresh insights and methodological advances with significant implications for quantitative finance and asset pricing.
key_findings bullet 4 · key_findings · validation V0
Raw abstract and provenance
- … these outcomes with data on asset returns and options to illustrate how greed-driven model switching can indeed generate volatility smiles, return predictability, and sus…
Source row: 1345 · abstract type: snippet