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Purpose – This paper aims at developing a behavioral agent-based model for interacting ﬁnancial markets. Additionally, the effect of imposing Tobin taxes on market dynamics is explored. Design/methodology/approach – The agent-based approach is followed to capture the highly complex, dynamic nature of ﬁnancial markets. The model represents the interaction between two different ﬁnancial markets located in two countries. The artiﬁcial markets are populated with heterogeneous, boundedly rational agents. There are two types of agents populating the markets; market makers and traders. Each time step, traders decide on which market to participate in and which trading strategy to follow. Traders can follow technical trading strategy, fundamental trading strategy or abstain from trading. The time-varying weight of each trading strategy depends on the current and past performance of this strategy. However, technical traders are loss-averse, where losses are perceived twice the equivalent gains. Market makers settle asset prices according to the net submitted orders. Findings – The proposed framework can replicate important stylized facts observed empirically such as bubbles and crashes, excess volatility, clustered volatility, power-law tails, persistent autocorrelation in absolute returns and fractal structure. Practical implications – Artiﬁcial models linking micro to macro behavior facilitate exploring the effect of different ﬁscal and monetary policies. The results of imposing Tobin taxes indicate that a small levy may raise government revenues without causing market distortion or instability. Originality/value – This paper proposes a novel approach to explore the effect of loss aversion on the decision-making process in interacting ﬁnancial markets framework. Keywords Loss aversion, Agent-based model, Fractal structure, Simulation analysis Paper type Research paper 1. Introduction Tobin (1978) argues that imposing small, uniform taxes on all ﬁnancial transactions would penalize short-term speculations and, hence, stabilize the ﬁnancial market. Many European Union countries impose taxes on ﬁnancial transactions. However, introducing ﬁnancial transaction taxes in other ﬁnancial markets is still under debate. Proponents believe that a levy of ﬁnancial transaction taxes would provide sizeable revenues to governments. On the other hand, contrarians argue that introducing transaction taxes to ﬁnancial markets would reduce market liquidity and a higher price volatility would be ensued. Additionally, the © Heba M. Ezzat. Published in Review of Economics and Political Science. Published by Emerald Review of Economics and Political Publishing Limited. This article is published under the Creative Commons Attribution (CC BY 4.0) Science Vol. 5 No. 2, 2020 licence. Anyone may reproduce, distribute, translate and create derivative works of this article (for pp. 94-115 both commercial and non-commercial purposes), subject to full attribution to the original publication Emerald Publishing Limited e-ISSN: 2631-3561 and authors. The full terms of this licence may be seen at http://creativecommons.org/licences/by/4.0/ p-ISSN: 2356-9980 DOI 10.1108/REPS-03-2019-0037 legalcode growing role of electronic brokering would increase tax evasion possibilities. This results in Agent-based reducing the Tobin tax’s ability to yield revenues. framework Hesitation of imposing a levy could be due to the unexpected results of market crashes or instability. Collateral effects can be avoided by exploring the impact of regulatory policies on the dynamics of artiﬁcial ﬁnancial markets. The effect of imposing Tobin taxes on the dynamics of artiﬁcial ﬁnancial markets has been studied in many studies (Westerhoff and Dieci, 2006; Westerhoff, 2008; Stanek and Kukacka, 2017). However, none of these studies has considered the effect of behavioral biases on trader’s decision-making process. The expected utility theory has led the analysis of decision-making under uncertainty. Utility expectations was perceived as a normative model of rational choice (Eiselt and Marianov, 2011) and formulated as a descriptive model of economic behavior (Friedman and Savage, 1948; Neve et al.,2015). Therefore, it was assumed that all rational economic agent would follow the utility theory most of the time. Markowitz (1952) proposes that utility should be deﬁned on gains and losses rather than on ﬁnal wealth states. Later, Kahneman and Tversky described several choice problems in which preferences under uncertainty violate the axioms of the expected utility theory (Kahneman and Tversky, 1979, 1984, 1991, 1992; Kahneman et al., 1990). Kahneman and Tversky reveal that risk aversion in the positive domain is associated with risk-seeking in the negative domain; this effect is known as the reﬂection effect. These propositions establish an alternative description model for decision-making under risk, called the prospect theory. According to the prospect theory, people normally perceive outcomes as gains and losses, instead of ﬁnal states of wealth. However, gains and losses are deﬁned relative to some reference point, which may correspond to the current wealth position. Additionally, gains and losses could be deﬁned as the actual received or paid amounts. As proposed by Kahneman and Tversky (1979), a value function for changes of wealth is concave above a reference point and convex below it. Accordingly, the proposed S-shaped value function is deﬁned on deviations from the reference point; concave for gains and convex for losses and steeper for losses than for gains. The main behavior affecting responses to changes in wealth is that the pain of losing a sum of money seems to be greater than the happiness associated with gaining the same amount. These ﬁndings have been supported by recent studies (McGraw et al., 2010; Neve et al., 2015). Few efforts have been spent to introduce behavioral biases to agent-based models (Takahashi and Terano, 2003; Lovric et al., 2010; Li et al., 2014; Selim et al.,2015; Ezzat, 2016; Feldman and Lepori, 2016). For instance, Selim et al. (2015) investigate the effect of loss- aversion behavioral bias on the switching behavior between technical and fundamental trading strategies, market stability and price distortions. The authors study market dynamics under two assumptions: (1) chartists are loss-neutral; and (2) chartists are loss-averse. The results reveal that most of the traders prefer fundamental analysis over technical analysis. Henceforth, loss aversion improves the market by minimizing its volatility and distortion. Nevertheless, the above models are not designed to explore the dynamics of interacting ﬁnancial markets. Studying the interaction between international ﬁnancial markets is of crucial importance, especially after the recent global ﬁnancial crisis (Westerhoff and Dieci, 2006; Schmitt and Westerhoff, 2014). The main contributions of this paper are: REPS introducing loss-aversion behavioral bias to the framework of interacting ﬁnancial 5,2 markets proposed by Westerhoff and Dieci (2006); investigating the dynamics of interaction between two ﬁnancial markets populated with loss-averse agents; and examining the effect of levying transaction taxes on markets stability, price distortion and the switching behavior between interacting markets following two different trading strategies; fundamental and technical analysis. The aforementioned models can replicate some important stylized facts, which are common statistical features observed in most ﬁnancial markets. Signiﬁcant stylized facts are usually formulated in terms of qualitative and quantitative properties such as price bubbles and market crashes, random-walk prices, clustered volatility, excess volatility and long memory (Mandelbrot, 1963; Fama, 1970; Guillaume et al.,1997; Cont, 2001; Cont, 2005; Haas and Bigorsch, 2011). A simple behavioral agent-based model of two interacting ﬁnancial markets is developed. The model is structured as follows. The markets are populated with two types of agents; market makers and traders. At each time step, traders decide either to trade or to stay inactive. Active traders follow technical or fundamental trading strategy as suggested by previous surveys (Taylor and Allen, 1992; Menkhoff, 1997; Frankel and Froot, 1987a, 1987b, 1990) and laboratory experiments (Hommes, 2011). Technical trading aims at exploiting price trends. Conversely, fundamental trading seeks to take advantage of mean reversion. Traders can participate in one market at a time. The attractiveness of a trading strategy is determined by the performance of this strategy in most recent past, which demonstrates a learning behavior. Trading-strategy weights are computed using the discrete-choice model proposed by Manski and McFadden (1981). However, traders following technical analysis are loss-averse, where losses loom larger than equivalent gains. Accordingly, weights of technical trading are expressed in terms of a piecewise linear function proposed by the prospect theory (Kahneman and Tversky, 1979, 1984, 1991, 1992). There is a market maker located in each market. Market makers set asset prices according to the net submitted orders. For this purpose, a linear impact function proposed by Farmer and Joshi (2002) is followed. Agents interact indirectly through their inﬂuence on price adjustment. This affects the attractiveness of trading rules, which turns to affect the belief adaptation process. By simulation, the results show that the developed model can generate ﬁnancial time series that exhibit important stylized facts observed empirically such as bubbles and crashes, volatility clustering, power-law tails, long memory and fractal structures. Thereafter, the proposed model serves as a test-bed for policy makers to investigate the effect of levying taxes on ﬁnancial transaction. The impact of levying ﬁnancial transaction taxes on the market dynamics is extensively investigated. The rest of the paper is organized as follows. In Section 2, the proposed agent-based ﬁnancial market model is presented. Asset pricing dynamics is investigated in Section 3. Furthermore, the results of extensive Monte Carlo simulation are displayed. In Section 4, the effect of imposing transaction taxes on market dynamics is investigated. Section 5 concludes the paper. 2. The model There are two different stock markets, Market X and Market Z, located in two countries. It is assumed that the countries either share the same currency or have agreed upon a ﬁxed exchange rate. For simplicity, the two stock markets are assumed to be symmetric. Thereby, traders have no preference for one market over the other. There are two types of agents; Agent-based market makers and traders. In each time step t, t =0,1,[.. .], T, each trader decides either to framework submit orders or abstain from the market. If a trader chooses to submit an order, she/he can submit her/his order either to Market X or Market Z. In addition, the trader can follow either technical or fundamental trading rule. Therefore, if the trader decides to submit an order, she/he would choose between ﬁve trading alternatives (two different stock markets and three different trading actions). Market makers settle asset prices following a log-linear price impact function suggested by Farmer and Joshi (2002). This function measures the relation between the orders quantity (demand/supply) and the price of the asset. Thus, asset log price in period t þ 1 for Markets X and Z, can be given by: X X Xc Xc Xf Xf X p ¼ p þaw D þ w D þ a ; (1) tþ1 t t t t t t and: Z Z Zc Zc Zf Zf Z p ¼ p þaw D þ w D þ a ; (2) tþ1 t t t t t t X Z where p and p are the log prices at time t in Markets X and Z, respectively, a is a t t Xc Zc positive price settlement parameter, D and D are the orders submitted at time t by t t Xf Zf chartists to Markets X and Z, respectively, D and D are the orders submitted at time t t t Xf Xc by fundamentalists to Markets X and Z, respectively, w and w are the weights of t t Zf Zc technical and fundamental strategy, respectively, in Market X at time t,and w and w t t are the weights of chartists and fundamentalists, respectively, in Market Z at time t.To X Z make the assumptions close to the real markets, noise terms a and a are added to catch t t any random factors affecting the price settlement process in Markets X and Z, X Z respectively. It is assumed that a and a , t =1,2,[...], T are independent, identically t t distributed (IID) normally distributed random variables with mean zero and constant X Z standard deviations s and s , respectively. a a Chartists follow technical analysis to exploit price changes (Murphy, 1999). Technical trading orders submitted to Markets X and Z, respectively, at time t can be written as: Xc X X X D ¼ bp p þ b ; (3) t t t1 t and: Zc Z Z Z D ¼ bp p þ b ; (4) t t t1 t where b is a positive reaction parameter (also called extrapolating parameter) that captures the sensitivity of chartists to price changes. The ﬁrst term at the right-hand side of equations (3) and (4) represents the difference between the current and last price, which indicates the exploitation of price changes. The second term captures additional random orders of technical X z trading rules. b and b ; t ¼ 1; 2; ... ; T are IID normally distributed random variables with t t X Z mean zero and constant standard deviation s and s , respectively. b b Fundamental analysis assumes that prices will revert to their fundamentals in the short REPS run (Graham and Dodd, 2009). Orders submitted by fundamentalists to Markets X and Z at 5,2 time t can be descried by: Xf X X X D ¼ cf p þ g ; (5) t t t t and: Zf Z Z Z D ¼cf p þ g ; (6) t t t t where c is a reaction parameter (also called a reverting parameter) that captures the X Z sensitivity of fundamentalists to price mean reversion. f and f are log-fundamental t t values (or simply fundamental values) (Day and Huang, 1990). The ﬁrst term at the right- hand side of equations (5) and (6) represents market distortion at time t, which computes the X Z deviation of index prices from their fundamentals, dist = f – p . g and g are introduced t t t t t to capture additional random orders of fundamental trading rules. g and g ; t ¼ 1; 2; .. . ; T are IID normally distributed random variables with mean zero and X Z constant standard deviations s and s , respectively. The log-fundamental values are g g assumed to evolve following a random walk such that: X X X f ¼ f þ h (7) t t1 t and: Z Z Z f ¼ f þ h ; (8) t t1 t X Z X where h and h are fundamental shock values in Markets X and Z, respectively. h and t t t h ; t ¼ 1; .. . ;T are IID normally distributed with mean zero and constant standard deviations s X and s Z , respectively. It is assumed that fundamental volatilities are equal h h in both markets. It is also assumed that fundamental traders can calculate the fundamental values. The evolutionary part of the model depicts how beliefs are evolving over time (Brock and Hommes, 1998). That is, how agents adapt their beliefs and switch between strategies. Belief no Xf Zf Xc Zc 0 0 adaptation is mirrored in the strategy weights w ; w ¼ w ; w ; w ; w ; w , where w t t t t t t t t Xf Zf Xc Zc represents the weight of inactive agents and w ; w ; w ; w are as indicated in t t t t equations (1) and (2). Strategy weights are updated according to evolutionary ﬁtness measures (or attractiveness of the trading rules) which can be presented as: Xc X X Xc X X X Xc A ¼ exp p exp p D tax exp p exp p D t t t1 t2 t t1 t2 (9) Xc þ mA ; t1 Xf Xf Xf X X X X X A ¼ exp p exp p D tax exp p exp p D t t t t1 t2 t1 t2 (10) Xf þ mA ; t1 Agent-based Zc Z Z Zc Z Z Z Zc A ¼ exp p exp p D tax exp p exp p D t t t t1 t2 t1 t2 (11) framework Zc þ mA ; t1 Zf Zf Zf Z Z Z Z Z A ¼ exp p exp p D tax exp p exp p D t t t1 t2 t t1 t2 (12) Zf 99 þ mA ; t1 and: A ¼ 0; (13) Xf Zf Xc Zc 0 where A , A , A , A and A are the ﬁtness measures of following chartist strategy in t t t t t Market X, chartist strategy in Market Z, fundamental strategy in Market X, fundamental strategy in Market Z and no-trade strategy, respectively. Inactive traders got zero attractiveness for abstaining from trading. The ﬁtness measure of the other two trading rules, the technical and the fundamental analysis, depends on three components. The ﬁrst term of the right-hand sides of equations (9)-(12) is the performance of the strategy rule in the most recent time. Notice that orders submitted in period t – 2 are executed at the price declared in period t – 1. Gains or losses are recognized according to prices announced in period t. The second term of the right-hand side of equations (9)-(12) represents the costs of X z trading in terms of transaction taxes, where tax is the tax rate of Market X and tax is the tax rate of Market Z. The third term of the right-hand side of equations (9)-(12) denotes agents’ memory, where 0# m# 1 is the memory parameter that measures the speed of recognizing current myopic proﬁts. Loss-aversion behavioral bias is proposed, inspired by Selim et al. (2015), where chartists evaluate their strategy ﬁtness in terms of a value function of gains and losses (Tversky and Kahneman, 1991; Benartzi and Thaler, 1993). The proposed value function implies that the pain of losses is twice the satisfaction of equivalent gains. Therefore, the attractiveness of technical strategy is given by: Xc Xc A if A 0 Xc t t v ¼ ; (14) t Xc Xc lA if A < 0 t t Zc Zc A if A 0 Zc t t v ¼ ; (15) t Zc Zc lA if A < 0 t t where l > 1 is the parameter of loss aversion that measures the relative sensitivity to gains Xc Xc Zc Zc and losses. However, setting l = 1 reduces the value functions to v ¼ A and v = A ; t t t t this case can be called loss-neutral chartists (Selim et al., 2015). Following Manski and McFadden (1981), the weight of each strategy can be obtained by the discrete-choice model as: Xc exp rv Xc t w ¼ ; (16) Xf Zf Xc Zc 1 þ exp rv þ exp rA þ exp rv þ exp rA t t t t Xf REPS exp rA Xf w ¼ ; (17) 5,2 Xf Zf Xc Zc 1 þ exp rv þ exp rA þ exp rv þ exp rA t t t t Zc exp rv Zc t w ¼ ; (18) 100 Xf Zf Xc Zc 1 þ exp rv þ exp rA þ exp rv þ exp rA t t t t Zf exp rA Zf w ¼ ; (19) Xf Zf Xc Zc 1 þ exp rv þ exp rA þ exp rv þ exp rA t t t t and: 0 Xc Zc Xf Zf w ¼ 1 w w w w : (20) t t t t t Trading strategy weights are proportional to strategy attractiveness. Parameter r in equations (16)-(19) is called the intensity of choice, and it measures the agent’s sensitivity to select the trading strategy with higher ﬁtness measure. 3. Simulation results and analyses 3.1 Calibration and simulation design In this section, the model is validated by investigating the extent to which it is able to replicate the stylized facts observed empirically. The values of model parameters are chosen such that the model can mimic the dynamics of real ﬁnancial markets. For the detailed declaration of the idea behind choosing speciﬁc values of the parameters, the reader can refer to Westerhoff and Dieci (2006). The proposed artiﬁcial ﬁnancial market is implemented using NetLogo platform (Unsupported source type (ElectronicSource) for source Wilensky, 1999). At initialization, all parameters of the model are equal to the values deﬁned in Table I. The performance of 1,000 simulation runs is investigated. Each run contains 5,000 daily observations. In the following, the evolutionary dynamics of the proposed model are discovered. 3.2 Stylized facts replication Before engaging in a comprehensive Monte Carlo simulation, it is important ﬁrst to observe a representative simulation run. Figures 1-8 depict the behavior of this speciﬁc run. Figure 1 illustrates the evolution of log-prices for the two markets. Note that the prices oscillate around their fundamental values. The average market distortion can be computed as T X dist ¼ jdist j, which exhibits a value of 11.49 per cent for dist and a value of 8.54 per t¼1 cent for dist . The two price series are random walk and display bubbles and crashes. These results are in good agreement with the stylized facts observed empirically. Figure 2 displays returns of the two markets. It can be observed that extreme returns reach up to 6 20 and6 10 per cent for Market X and Z, respectively. Following Guillaume et al. (1997), volatility can be calculated as the average absolute returns (vol) 1 X vol ¼ jr j. The computed average volatilities are 1.35 and 1.07 per cent for vol and T t¼1 Agent-based Parameter Value Description of parameter framework a 1 Price settlement parameter b 0.05 Extrapolating parameter c 0.05 Reverting parameter m 0.975 Memory parameter r 300 Intensity of choice parameter l 2.5 Loss aversion parameter tax 0 Tax rate of Market X tax 0 Tax rate of Market Z s 0.01 Standard deviation of the random factors affecting the price settlement process in Market X s 0.01 Standard deviation of the random factors affecting the price settlement process in Market Z s 0.05 Standard deviation of the additional random orders of technical Table I. trading orders submitted to Market X Parameters for the s 0.05 Standard deviation of the additional random orders of technical simulation of the two trading orders submitted to Market Z interacting ﬁnancial s 0.01 Standard deviation of the additional random orders of fundamental markets under loss- trading orders submitted to Market X aversion behavioral s 0.01 Standard deviation of the additional random orders of fundamental bias trading orders submitted to Market Z 1.7 ـــــــــ p ــــــــــf –1.7 0 1,000 2,000 t 3,000 4,000 5,000 1.7 ـــــــــ p ــــــــــf Figure 1. Evolution of log- prices for the two –1.7 markets 0 1,000 2,000 3,000 4,000 5,000 vol , respectively, indicating excess volatility feature (Shiller, 1981). Also, Figure 2 shows another stylized fact of asset markets, which is volatility clustering. Figure 3 depicts the weights of the ﬁve trading strategies. The ﬁrst panel in Figure 3 displays the average weights, which are computed as 20, 25.6, 19.2, 20.4 and 14.8 per cent for Xf Zf Xc 0 Zc w , w , w , w and w , respectively. Note the higher volatility in Market X than that in t t t t t Market Z, which can be explained by the higher participation of chartists in Market X than that in Market Z. Additionally, these results show that 34.8 (46) per cent of the agents follow technical (fundamental) trading. The effect of loss-aversion behavioral bias can be explored by running a simulation using the same random seeds and the parameter setting illustrated p p 0.2 REPS 5,2 –0.2 0 1,000 2,000 t 3,000 4,000 5,000 0.2 Figure 2. Returns of the two –0.2 markets 0 1,000 2,000 t 3,000 4,000 5,000 0.5 wc1t wf1t wc2t 0.5 Notes: The first (second) panel shows the weights of the five trading strategies when λ = 2.5(λ = 1). The panels illustrate, from top to bottom, Figure 3. chartists in market X (black), fundamentalists in market X (white), no Weights of trading trading (grey), fundamentalists in market Z (white), and chartists in market strategies Z (black) in Table I except for l = 1. Differences in the dynamics are merely due to loss-aversion behavior. The second panel in Figure 3 depicts the average weights, which are computed as Xf Zf Xc 0 Zc 22.9, 17.2, 17.5, 18.7 and 23.6 per cent for w , w , w , w and w , respectively. Henceforth, t t t t t 46.5 (35.9) per cent of the agents follow technical (fundamental) trading. Accordingly, loss aversion causes agents to prefer fundamental trading over technical trading. The increased 2,001 2,251 2,501 2,751 3,001 3,251 3,501 3,751 4,001 2,001 4,251 2,251 4,501 2,501 4,751 2,751 5,001 3,001 3,251 3,501 3,751 4,001 4,251 4,501 4,751 5,001 1,001 1,251 1,501 1,751 1,001 1,251 1,501 1,751 Z X r r w t t shares of chartists come at the cost of increased market volatilities, which are computed as Agent-based X Z 1.38 and 1.11 per cent for vol and vol , respectively. framework However, the results of 1,000 simulation runs using different random seeds and the parameter setting displayed in Table I reveal that the mean of average weights is estimated Xf Zf Xc 0 as 17 per cent for w , 23 per cent for w , 20 per cent for w , 23 per cent for w and 17 per t t t t Zc cent for w . Thereafter, 34 per cent of the agents follow technical trading. Moreover, 46 per cent of the agents preferred fundamental trading. As the two markets are assumed to be symmetric, chartists and fundamentalists are equally participated in both markets. Subsequently, no market is preferred over the other. In addition, the reduction in technical trading can be due to the loss-aversion behavior. Another signiﬁcant stylized fact is power-law tails, with a tail index somewhere in the region 2-5. The exponent a of the Pareto distribution for the tails can be expressed by the following inverse cubic law: ProbðÞ jr j > x x ; (21) with a (Lux and Marchesi, 1999; Lux, 2009; Haas and Bigorsch, 2011). To check the r 3 power-law tails, the Hill index tail estimate is calculated for the smallest and largest 10 per cent of the observations. Figure 4 illustrates the Hill index tails estimation process (Hill, 1975; Huisman et al., 2001). Regression on the smallest (largest) 10 per cent of the observations yields a value of 2.856 0.049 (2.406 0.048) for Market X and a value of 4.096 0.079 (3.516 0.072) for Market Z. These results are in good accordance with the inverse cubic law of (21). Another astonishing stylized fact to be investigated is the absence of autocorrelation in raw returns. Figure 5 represents autocorrelations for the ﬁrst 100 lags of raw returns for both markets. The dashed lines present 95 per cent conﬁdence bands according to the 5 5 ــــــــــαˆ ــــــــــαˆ ---- fit ---- fit 1.5 1.5 0 100 200 300 400 500 0 100 200 300 400 500 k k j j 5 5 ــــــــــαˆ ــــــــــαˆ - - - - fit ---- fit 1.5 1.5 0 100 200 300 400 500 0 100 200 300 400 500 Figure 4. The estimated Hill Notes: The panels at top (bottom) depict estimated Hill tail-index for market X(Z). The tail index for the two panels show the estimates of the smallest 10 per cent observations (on the left-hand sides) markets and the largest 10 per cent observations (on the right-hand sides) αˆ αˆ kj kj αˆ αˆ kj kj assumption of a white noise process. The raw returns for the two markets show REPS autocorrelation coefﬁcients, which are not signiﬁcant over 100 lags. This implies the 5,2 randomness of asset prices. To study the predictability of asset volatility, autocorrelation in absolute returns is studied. The two panels in Figure 6 depict autocorrelations for the ﬁrst 100 lags of absolute returns for the two markets. The dashed lines present 95 per cent conﬁdence bands according to the assumption of a white noise process. The panels show that absolute returns are signiﬁcantly autocorrelated for up to 100 (30) lags in Market X (Z). Thus, volatility can be partially predicted (with no signiﬁcant prediction of the direction of price movements). Another important fact of the ﬁnancial markets is self-similarity as recognized by Mandelbrot (1983). To investigate self-similarity, detrended ﬂuctuation analysis (DFA) is performed following Peng et al. (1994). Linear relationship on a log-log scale between the average ﬂuctuation, F , and the time scale, n, shows scaling structure of asset returns. Figure 7 depicts the estimation of the scaling exponent, H , for raw returns of Markets X and Z. A value of H = 0.5 indicates a white-noise process, a value of 0.5 < H < 1 corresponds to long-range power-law autocorrelations and a value of 0 < H < 0.5 indicates that large and small oscillations of the time series are very likely to alternate. The scaling exponent H yields a value of 0.506 0.029 for Market X and a value of 0.526 0.005 for Market Z. Consequently, estimated values of the scaling exponent show white-noise processes. Figure 8 presents the estimation of the scaling exponent, H , for absolute asset returns. |r| The scaling exponent H yields a value of 0.896 0.090 for Market X and a value of |r| 0.2 –0.2 0 20 40 60 80 100 Lag 0.2 Figure 5. Autocorrelation in raw returns of the –0.2 0 20 40 60 80 100 two markets Lag 0.4 –0.4 0 20 40 60 80 100 Lag 0.4 Figure 6. Autocorrelation in absolute returns of –0.4 0 20 40 60 80 100 the two markets Lag AC AC AC AC |r Z| |rX| rZ rx –1 Agent-based framework –2 raw returns linear fit –3 1 2 3 4 5 10 10 10 10 10 105 –1 –2 raw returns linear fit –3 Figure 7. 1 2 3 4 5 10 10 10 10 10 Estimation of self- similarity parameter for raw returns of the Notes: The slope of the line relating log (F(n)) to log (n) is the estimated assets 3 10 scaling exponent, n ={2 ,…,2 } –2 absolute returns linear fit –4 1 2 3 4 5 10 10 10 10 10 –2 absolute returns linear fit Figure 8. –4 Estimation of self- 1 2 3 4 5 10 10 10 10 10 similarity parameter for absolute returns of the two return Note: The slope of the line relating log (F(n)) to log (n) is the estimated series 3 10 scaling exponent, n = {2 ,…,2 } 0.736 0.068 for Market Z. Estimated values of the scaling exponent indicate long-range power-law autocorrelations in absolute returns. Thereafter, the simulation run illustrated in Figures 1-8 imitates the behavior observed in real ﬁnancial markets remarkably well. In what follows, the robustness of these results is Z X Z X F (|r| ) F (|r| ) F (r ) F (r ) n n n n investigated by performing a thorough Monte Carlo analysis. The analysis relies on 1,000 REPS simulation runs, each comprising 5,000 observations. All simulation runs are executed with 5,2 the parameter setting offered in Table I using different seeds of the random variables. Table II reports estimates of the mean and median of the mean, maximum, minimum, standard deviation, skewness and kurtosis for the two markets. Estimates of the mean and the median of the kurtosis for the two return series are all greater than 3, indicating leptokurtosis. Table III illustrates estimates of the mean and the median of the Hill tail index estimators a ^ for k [ {2.5, 5, 10} {2.5, 5, 10} per cent of the smallest (left tail) and largest (right tail) returns for the two assets. For example, considering the smallest (largest) 5 per cent of observations of r , estimate of the tail index displays a value of 3.63 (3.09) for the median. The results show that the average Hill tail index estimates of the largest and smallest 10 per cent observations are in good agreement with the universal cubic law (see (21)). Table IV displays estimates of the mean and the median of autocorrelation in raw ‘ ‘ returns, AC , for lags ‘ [ {1,2,3}[, and autocorrelation in absolute returns, AC , for lags ‘ [ r jrj Market Mean/median Mean Minimum Maximum SD Skewness Kurt X Mean 3.35 * 10 0.11 0.11 0.02 0.00 3.89 Median 5.62 * 10 0.11 0.11 0.02 0.01 3.64 Z Mean 1.49 * 10 0.11 0.11 0.02 0.00 3.84 Median 3.09 * 10 0.11 0.11 0.02 0.00 3.55 Table II. Descriptive statistics Notes: The table reports the estimates of the mean and the median of the mean, maximum, minimum, for asset returns of standard deviation, skewness and kurtosis; computations are based on 1,000 time series, each containing the two markets 5,000 observations Left-tail exponent Right-tail exponent Asset Mean/median a ^ a ^ a ^ a ^ a ^ a ^ 2:5% 5% 10% 2:5% 5% 10% r Mean 3.55 3.60 3.50 2.79 3.18 3.37 Median 3.56 3.63 3.35 2.79 3.09 3.21 r Mean 3.57 3.62 3.51 2.79 3.19 3.39 Median 3.60 3.63 3.39 2.78 3.13 3.25 Table III. The Hill tail index Notes: The table reports the estimates of the mean and the median of the Hill tail index estimatorsÞ a ^ for estimatorÞ a ^ for the k [ {2.5, 5, 10} per cent of the smallest (left-tail) and largest (right-tail) returns of the two markets; left and right tails computations are based on 1,000 time series, each containing 5,000 observations 1 2 3 1 20 50 100 Asset Mean/median AC AC AC AC AC AC AC r r r jrj jrj jrj jrj r Mean 0.09 0.07 0.07 0.32 0.22 0.13 0.07 Median 0.03 0.01 0.01 0.28 0.17 0.09 0.02 r Mean 0.03 0.01 0.01 0.27 0.17 0.08 0.02 Table IV. Median 0.03 0.01 0.01 0.28 0.17 0.08 0.02 Autocorrelations for raw and absolute Notes: The table displays the estimates of the mean and the median of the autocorrelation in raw returns, ‘ ‘ returns of both AC , for lags ‘ [ {1,2,3}, and the autocorrelation in absolute returns, AC ,for lags ‘ [ {1,20,50,100}; r jrj markets computations are based on 1,000 time series, each containing 5,000 observations ‘ Agent-based {1, 20, 50,100}. Estimates of the median of autocorrelation coefﬁcients AC indicate that price changes are mainly uncorrelated. For instance, the estimate of the median of framework X Z autocorrelation coefﬁcients AC reveals a value of 0.03 for r and a value of 0.03 for r . This is in line with most real ﬁnancial markets, where asset price evolves according to a random walk. Estimate of the median of autocorrelation coefﬁcients AC reveals a value of 0.28 for jrj X Z r and a value of 0.28 for r , indicating persistence in volatility. Finally, the robustness of the scaling behavior and fractal structure is needed to be checked. Table V displays the estimates of the mean and the median for the scaling exponent of raw returns, H , and the scaling exponent of absolute returns, H . Estimate of r |r| X Z the median of H reveals a value of 0.50 for r and a value of 0.49 for r . These ﬁgures indicate a small degree for predicting asset returns. Furthermore, estimate of the median of X Z H reveals a value of 0.79 for r and a value of 0.78 for r . These values display long-range |r| power-law autocorrelations in absolute returns. Summing up, the model replicates the stylized facts of real ﬁnancial markets remarkably well. Thereafter, the model can serve as a testbed to examine the effect of levying transaction taxes on the agents’ switching behavior. For this purpose, two scenarios are to be investigated. First, the impact of imposing taxes in one market only. Second, the impact of imposing taxes in the two markets. The results of these scenarios are illustrated in the following section. 4. The dynamics with transaction taxes 4.1 Transaction taxes in one market To explore the impact of imposing transaction taxes in one market only, a transaction tax of 0.25 per cent is imposed in one market, e.g. Market X (as the two markets are assumed to be symmetric, the results would not be changed if Market Z is selected). Figure 9 displays a simulation run using the same random seeds for the simulation presented in Figures 1-8. The simulation is executed based on the parameter setting presented in Table I, except for tax = 0.0025. Thereafter, differences in the dynamics are merely due to taxation. Figure 9 can be compared directly with Figures 1, 2 and the ﬁrst panel in Figure 3. The ﬁrst two panels in Figure 9 show evolution of the log prices. Price bubbles and market crashes can be observed. Moreover, prices oscillate around their fundamentals. The third and fourth panels in Figure 9 show asset returns. The return series exhibit excess volatility and clustered volatility as observed in real ﬁnancial markets. The last panel in Figure 9 illustrates the weights of the ﬁve trading strategies. No trading strategy dominates the others. Surprisingly, the average weights are computed as 20, 25.6, 19.2, 20.4 and 14.8 per cent for Xf Zf Xc 0 Zc w , w , w , w and w , respectively. Additionally, the computed average volatilities are t t t t t X Z 1.35 and 1.07 per cent for vol and vol , respectively, and the computed average market X Z distortions are 11.49 and 8.54 per cent for dist and dist , respectively. These are the same X Z r r Measures of central tendency H H H H r |r| r |r| Mean 0.50 0.78 0.50 0.78 Table V. Median 0.50 0.79 0.49 0.78 Scaling exponent for raw and absolute Notes: Estimates of the mean and the median of the scaling exponent of raw returns, H , and the scaling returns of the two exponent of absolute returns, H ; computations are based on 1,000 time series, each containing 5,000 |r| observations markets 1.7 REPS 5,2 ـــــــــ p ــــــــــf –1.7 0 1,000 2,000 t 3,000 4,000 5,000 1.7 ـــــــــ p ــــــــــf –1.7 0 1,000 2,000 t 3,000 4,000 5,000 0.2 –0.2 0 1,000 2,000 3,000 4,000 5,000 0.2 –0.2 0 1,000 2,000 t 3,000 4,000 5,000 0.5 Figure 9. The impact of imposing a transaction tax of wc1t wf1t w0t 0 wf2t wc2t 0.25 per cent in market X on both markets’ log prices, Notes: The first two panels show evolution of log prices in markets X and Z, respectively. asset returns and The third and fourth panels display asset returns of markets X and Z, respectively. The last panel weights of trading illustrates, from top to bottom, chartists in market X (black), fundamentalists in market X (white), strategies no trading (grey), fundamentalists in market Z (white), and chartists in market Z (black) 2,001 2,251 2,501 2,751 3,001 3,251 3,501 3,751 4,001 4,251 4,501 4,751 5,001 1,001 1,251 1,501 1,751 Z X Z r r p p t ﬁgures obtained from the simulation run presented in Figures 1-8. Thereafter, levying taxes Agent-based in one market does not affect market dynamics in both markets. framework To check the robustness of these results, a comprehensive Monte Carlo analysis is applied. The analysis relies on 1,000 simulation runs for each tax rate, which is increased from 0.05 to 0.5in20steps.Eachsimulationiscomprised of 5,000 observations. All simulation runs are executed based on the parameter setting offered in Table I using different seeds of the random variables. Figure 10 depicts the results of the Monte Carlo simulation for the ﬁrst scenario. Figure 10 displays the average volatility for both markets, average price distortion for both markets and average weights of the ﬁve trading strategies. The ﬁrst panel in Figure 10 depicts that volatility of both markets ﬂuctuate around 1.18 per cent. Which tax rate would stabilize the markets? There is no speciﬁc tax rate that would decrease volatility in both markets at the same period. However, there is no tax rate that cause drastic increase in market volatility. The same result is observed from the second panel in Figure 10. No signiﬁcant deviation in market 1.3 1.2 1.1 0 0.1 0.2 0.3 0.4 0.5 Tax rate volX volZ 11.2 10.2 9.2 0 0.1 0.2 0.3 0.4 0.5 Tax rate distX distZ 0.24 0.2 0.16 0 0.1 0.2 0.3 0.4 0.5 Tax rate wXct wZct wX wZ w0t Figure 10. The impact of Notes: The panels (from the top) show market volatility, imposing taxes in price distortion, and the weights of each trading strategy. market X on the Tax rate is increased from 0.05 to 0.5 per cent in 20 steps. dynamics of the two Computations are based on 1000 time series, each containing markets 5000 observations w distotion volatility distortion can be noticed. The last panel in Figure 10 indicate the weights of trading strategies, REPS which are around 46, 34 and 20 per cent for fundamentalists, chartists and inactive traders, 5,2 respectively, in both markets. In addition, chartists and fundamentalists are almost equally participated in both markets. Thereby, imposing transaction taxes in one market may not affect market stability or price distortion. Moreover, there is no strong evidence that traders would prefer trading in the market without transaction taxes. The traders also prefer fundamental trading over technical trading. However, this is the same result obtained from the model without introducing transaction taxes. 4.2 Transaction taxes in both markets To explore the impact of imposing transaction taxes in the two markets, a transaction tax of 0.25 per cent is imposed in both markets. Figure 11 displays a simulation run based on the same random seeds of the simulation run depicted in Figures 1-8 using the parameter setting X Z presented in Table I, except for tax = 0.0025 and tax = 0.0025. Thereby, differences in the dynamics are only due to taxation. Figure 11 can be compared directly with Figures 1, 2 and the ﬁrst panel in Figure 3. The ﬁrst two panels in Figure 11 depict log-price evolution. The prices oscillate around their fundamentals and resemble the behavior of asset prices observed empirically. The third and fourth panels in Figure 11 illustrate asset returns, which exhibit excess volatility and volatility clustering as observed in real ﬁnancial markets. The last panel in Figure 11 illustrates the weights of the ﬁve trading strategies. Amazingly, the average weights are computed as 20, 25.6, 19.2, 20.4 and 14.8 per cent for Xf Zf Xc 0 Zc w , w , w , w , and w , respectively. Additionally, the computed average volatilities are t t t t t X Z 1.35 and 1.07 per cent for vol and vol , respectively. The computed average market X Z distortions are 11.49 and 8.54 per cent for dist and dist , respectively. These are the same ﬁgures obtained from the simulation run presented in Figures 1-9. Thereafter, levying taxes in the two interacting markets does not affect market dynamics in both markets. The robustness of these results is checked by applying a thorough Monte Carlo analysis. The analysis relies on 1,000 simulation runs for each tax rate, which is increased from 0.05 to 0.5 in 20 steps. Each simulation is comprised of 5,000 observations. All simulation runs are executed based on the parameter setting offered in Table I using different random seeds. Figure 12 depicts the results of the Monte Carlo simulation for the second scenario. Figure 12 shows average volatility for both markets, average price distortion for both markets and average weights of the ﬁve trading strategies. The ﬁrst panel in Figure 12 depicts that volatility of both markets ﬂuctuate around 1.18 per cent. In addition, different values of tax rates have slight effect on market volatilities in either direction. The same result is obtained for price distortions. No signiﬁcant deviation in market distortion can be noticed from the second panel in Figure 12. As indicated by the last panel in Figure 12, the weights of trading strategies are around 46, 34 and 20 per cent for fundamentalists, chartists and inactive traders, respectively, in both markets. Furthermore, chartists and fundamentalists are almost equally participated in the two markets. Thus, imposing transaction taxes in two interacting markets may not cause instability or price distortion in both markets. Moreover, the traders prefer fundamental trading over technical trading. Nevertheless, this is the same result obtained in the artiﬁcial markets with zero taxes and with a levy in one market only. It should be noted that the key difference between the proposed model and the model provided by Westerhoff and Dieci (2006) is the loss-aversion behavioral bias. Westerhoff and Dieci (2006) ﬁnd that imposing Tobin taxes in one market will result in stabilizing this market at the cost of the other market’s stability. Additionally, levying Tobin taxes in the two markets decreases volatility and distortion in both markets. The above authors report the average weight of 38, 45 and 17 per cent for fundamentalists, chartists and inactive traders, respectively. Note that the 1.7 Agent-based framework ـــــــــ p ــــــــــf –1.7 0 1,000 2,000 3,000 4,000 5,000 1.7 ـــــــــ p ــــــــــf –1.7 0 1,000 2,000 t 3,000 4,000 5,000 0.2 –0.2 0 1,000 2,000 t 3,000 4,000 5,000 0.2 –0.2 0 1,000 2,000 t 3,000 4,000 5,000 0.5 t Figure 11. 0 The impact of levying wc1t wf1t w0t wf2t wc2t a transaction tax of 0.25 per cent in markets X and Z on Notes: The first two panels show evolution of log prices in markets X and Z, respectively. both markets’ log The third and fourth panels display asset returns of markets X and Z, respectively. The last prices, asset returns panel illustrates, from top to bottom, chartists in market X (black), fundamentalists in and the weights of market X (white), no trading (grey), fundamentalists in market Z (white), and chartists in trading strategies market Z (black) 2,001 2,251 2,501 2,751 3,001 3,251 3,501 3,751 4,001 4,251 4,501 4,751 5,001 1,001 1,251 1,501 1,751 X Z X r r p p t 1.3 REPS 5,2 1.2 1.1 0 0.1 0.2 0.3 0.4 0.5 Tax rate volX volZ 11.2 10.2 9.2 0 0.1 0.2 0.3 0.4 0.5 Tax rate distX distZ 0.24 0.2 0.16 0 0.1 0.2 0.3 0.4 0.5 Tax rate wXct wZct wX wZ w0t Figure 12. The impact of Notes: The panels (from the top) show market volatility, imposing taxes in price distortion, and the weights of each trading strategy. markets X and Z on Tax rates are increased from 0.05 to 0.5 per cent in 20 steps. the dynamics of the Computations are based on 1000 time series, each containing two markets 5000 observations main assumptions and parameter values followed in this research are similar to those of Westerhoff and Dieci (2006), except for the loss-aversion behavior. Thereby, the difference in results can mainly be attributed to loss-aversion behavior, which stabilizes the market by managing the speculative behavior. Additionally, governments could levy small transaction taxes to generate extra revenues without worrying about market stability. 5. Conclusions In this paper, a behavioral agent-based model is proposed to provide a suitable testbed for policy makers. The proposed framework models the interaction between two different ﬁnancial markets; Market X and Market Z. There are two types of agents populating the artiﬁcial markets; traders and market makers. Each time step, traders decide on one of the trading strategies: distortion volatility technical trading in Market X; Agent-based fundamental trading in Market X; framework technical trading in Market Z; fundamental trading in Market Z;or abstain from trading. The weight of each trading strategy is determined according to past and current performance of this strategy. As chartists are loss-averse, losses loom larger than equivalent gains. The discrete-choice model is followed to compute the weights of trading strategies. Market makers update asset prices according to the net submitted orders. A log-linear price impact function is followed to settle asset prices. The proposed model can replicate stylized facts observed empirically such as bubbles and crashes, excess volatility, volatility clustering, absence of autocorrelation in raw returns, persistence in volatility, power-law tails and fractal structures. Thereby, the model can be used as a test-bed to investigate the effect of applying regulatory policies. Furthermore, loss-aversion behavioral bias affects agent switching behavior among trading strategies, which consequently enhances market stability. This can be explained as follows. The increase in price distortion causes the chartists to become aggressive. The increasing switching behavior to technical strategy will increase market volatility. As the distortion approaches its maximum value, traders perceive fundamental analysis as the most appealing strategy to follow. The increasing switch to the fundamental analysis will drag asset prices to their fundamentals and reduce market volatility and price distortion. 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Ezzat can be contacted at: h.m.ezzat@gmail.com For instructions on how to order reprints of this article, please visit our website: www.emeraldgrouppublishing.com/licensing/reprints.htm Or contact us for further details: permissions@emeraldinsight.com
Review of Economics and Political Science – Emerald Publishing
Published: Mar 19, 2020
Keywords: Loss aversion; Agent-based model; Fractal structure; Simulation analysis
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