BERND PAPE Asset Allocation, Multivariate Position Based Trading ...

72 ACTA WASAENSIASethi (1996) extends that model further by introducing information costs for fundamentalistsand explicitely considering the fluctuations in wealth and inventories of thetwo trader types. While chartists would loose their money to fundamentalists underabsence of information costs, this is no longer the case when information about fundamentalsis costly to obtain. The relative profitability of the two trading strategiesdepends then upon whether the market is within the stable or the oscillatory regime.In the oscillatory regime with large deviations between market and fundamental pricethefundamentalistapproachremainsthemoreprofitable investment style, whereasin the stable regime with prices near fundamental value profits are not sufficient tocover their information costs and chartism becomes more profitable. Chartists andfundamentalists entertain a symbiotic relationship in the sense that increasing wealthof chartists pushes the market into the oscillatory regime which fundamentalsits needin order to make their profits by driving the market back into the stable regime. As aresult, the market alternates continously between periods of stability and instability.This is similiar to the exchange rate model by DeGrauwe, Dewachter & Embrechts(1993), in which endogenously changing weigths of chartists and fundamentalists maygenerate periodic and even chaotic fluctuations of the exchange rate. Like in Sethi, thefraction of chartists increases endogenously with the mispricing of the foreign currency.This is however not motivated by wealth shares as in Sethi, but with offsetting tradesof fundamentalists near the fundamental equilibrium exchange rate.Chaotic price fluctuations are also generated in a non-linear variant of the Beja & Goldmanmodel in discrete time by Day & Huang (1990). They provide also a justificationof the price adjustment rule (4.6) in terms of a market maker. The market makersupplies stocks out of his inventory and raises the price if there is excess demand, whilehe accumulates stock to his inventory and lowers the price when there is excess supply.Even though Day & Huang do not explicitely model the market makers inventory, theydo stress the importance of keeping the latter in balance in order to ensure successfuloperation of the market pricing mechanism.Farmer (2002) and Farmer & Joshi (2002) provide the following derivation of an approximatelylinear relationship between asset returns and net asset demand D t from