Conjuncted Again: Noise Traders, Chartists and Fundamentalists: The In-Betweeners

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 κ_t 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

κ_t = (1 – ξ)/(1 + exp(Ψ(E^c_t – E^f_t)) —– (1)

E^c_t = (p_t – p^c_t)^2>, E^f_t = (p_t – p^f_t)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 E^c_t is smaller than that of fundamentalists E^f_t , some fraction of fundamentalists will become chartists, and visa versa.

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