The simulation of financial markets can be modeled, from a theoretical viewpoint, according to two separate approaches: a bottom up approach and (or) a top down approach. For instance, the modeling of financial markets starting from diffusion equations and adding a noise term to the evolution of a function of a stochastic variable is a top down approach. This type of description is, effectively, a statistical one.
A bottom up approach, instead, is the modeling of artificial markets using complex data structures (agent based simulations) using general updating rules to describe the collective state of the market. The number of procedures implemented in the simulations can be quite large, although the computational cost of the simulation becomes forbidding as the size of each agent increases. Readers familiar with Sugarscape Models and the computational strategies based on Growing of Artificial Societies have probably an idea of the enormous potentialities of the field. All Sugarscape models include the agents (inhabitants), the environment (a two-dimensional grid) and the rules governing the interaction of the agents with each other and the environment. The original model presented by J. Epstein & R. Axtell (considered as the first large scale agent model) is based on a 51 x 51 cell grid, where every cell can contain different amounts of sugar (or spice). In every step agents look around, find the closest cell filled with sugar, move and metabolize. They can leave pollution, die, reproduce, inherit sources, transfer information, trade or borrow sugar, generate immunity or transmit diseases – depending on the specific scenario and variables defined at the set-up of the model. Sugar in simulation could be seen as a metaphor for resources in an artificial world through which the examiner can study the effects of social dynamics such as evolution, marital status and inheritance on populations. Exact simulation of the original rules provided by J. Epstein & R. Axtell in their book can be problematic and it is not always possible to recreate the same results as those presented in Growing Artificial Societies. However, one would expect that the bottom up description should become comparable to the top down description for a very large number of simulated agents.
The bottom up approach should also provide a better description of extreme events, such as crashes, collectively conditioned behaviour and market incompleteness, this approach being of purely algorithmic nature. A top down approach is, therefore, a model of reduced complexity and follows a statistical description of the dynamics of complex systems.
Forward, Futures Contracts and Options: Let the price at time t of a security be S(t). A specific good can be traded at time t at the price S(t) between a buyer and a seller. The seller (short position) agrees to sell the goods to the buyer (long position) at some time T in the future at a price F(t,T) (the contract price). Notice that contract prices have a 2-time dependence (actual time t and maturity time T). Their difference τ = T − t is usually called time to maturity. Equivalently, the actual price of the contract is determined by the prevailing actual prices and interest rates and by the time to maturity. Entering into a forward contract requires no money, and the value of the contract for long position holders and strong position holders at maturity T will be
(−1)p (S(T)−F(t,T)) (1)
where p = 0 for long positions and p = 1 for short positions. Futures Contracts are similar, except that after the contract is entered, any changes in the market value of the contract are settled by the parties. Hence, the cashflows occur all the way to expiry unlike in the case of the forward where only one cashflow occurs. They are also highly regulated and involve a third party (a clearing house). Forward, futures contracts and options go under the name of derivative products, since their contract price F(t, T) depend on the value of the underlying security S(T). Options are derivatives that can be written on any security and have a more complicated payoff function than the futures or forwards. For example, a call option gives the buyer (long position) the right (but not the obligation) to buy or sell the security at some predetermined strike-price at maturity. A payoff function is the precise form of the price. Path dependent options are derivative products whose value depends on the actual path followed by the underlying security up to maturity. In the case of path-dependent options, since the payoff may not be directly linked to an explicit right, they must be settled by cash. This is sometimes true for futures and plain options as well as this is more efficient.