Interesting questions are whether the rational traders (fundamentalists) will drive irrational traders (chartists and noise traders) out of the market, or whether the irrational traders (chartists and noise traders) will derive the rational traders (fundamentalists) out of the market. As in many studies on heterogeneous interacting agent models, it may seem natural that switching between different trading strategies plays an important role. Now the question is: how a trader makes his choice between the fundamentalist and chartist strategies. The basic idea is that he chooses according to the accuracy of prediction. More precisely, the proportion of chartists κt is updated according to the difference between the squared prediction errors of each strategy. Formally, we write the dynamics of the proportion of chartists κ as
κt = (1 – ξ)/(1 + exp(Ψ(Ect – Eft)) —– (1)
Ect = (pt – pct)2>, Eft = (pt – pft)2
where ψ measures how sensitively the mass of traders selects the optimal prediction strategy at period t. This parameter was introduced as the intensity of choice to switch trading strategies. Equation 1 shows that if the chartists’ squared prediction error Ect is smaller than that of fundamentalists Eft , some fraction of fundamentalists will become chartists, and visa versa.