An Adaptive Model on Asset Pricing and Wealth Dynamics with Heterogeneous Trading Strategies

This paper develops an adaptive model on asset pricing and wealth dynamic of a financial market with heterogeneous agents and examines the profitability of momentum and contrarian trading strategies. In order to characterize asset price, wealth dynamics and rational adaptiveness arising from the interaction of heterogeneous agents with CRRA utility, an adaptive discrete time equilibrium model in terms of return and wealth proportions (among heterogeneous representative agents) is established. Taking trend followers and contrarians as the main heterogeneous agents in the model, the profitability of momentum and contrarian trading strategies is analyzed. Our results show the capability of the model to characterize some of the existing evidence on many of anomalies observed in financial markets, including the profitability of momentum trading strategies over short time intervals and of contrarian trading strategies over long time intervals, rational adaptiveness of agents, overconfidence and underreaction, overreaction and herd behavior, excess volatility, and volatility clustering. Date: First Version: Dec.10, 2001; Second Version: Jan. 15, 2002; Latest Version: May 22, 2002.