Dynamic instabilities induced by irrational behavior in financial marketscauses and consequences for risk assessment

Resumen

Understanding the mechanisms and characteristics of financial markets both in terms of risk and return is essential for the assessment of risk. The modern financial theory assumes that the risk of a diversified portfolio can be quantified by the overall margin of fluctuations and further that the expected return is a linear function of the respective risk. However, observable excess volatility beyond expected adjustments based on new information and resulting unstable prices can be attributed to speculative, irrational behavior. This cumulative dissertation contributes to a better understanding of dynamic instabilities induced by irrational behavior from a macro-economic perspective as well as its measurement and application in financial markets. Through the decomposition of price movements of financial assets in the spectral domain, short-term fluctuation based on rational adjustments to new information can be distinguished from medium term fluctuations unexplainable by rational behavior. The new risk measure - irrationality - based on this classification can be clearly distinguished from volatility both in terms of its underlying components and in terms of its explanatory power. It differs, in that it does not consider the overall margin of fluctuations, but rather represents a ratio of the relative impact of rational and irrational fluctuations on the price movements. The findings from empirical analysis of the constituents of major indices indicate a negative relationship between risk and return in terms of irrationality. The effect is statistically significant and remarkably evident. Broad application of the concept may lead to falling prices of highly speculative investments and a reduction in animal spirits of investors. Market exuberances may thereby be reduced, and subsequent downturns mitigated.