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How Prospect-Based Trading Behavior Can Shape Price Volatility

Article arXiv papers · Author: Yipeng Yang et al.
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Summary

This paper proposes a microeconomic model in which market participants act as prospect agents, responding to gains and losses. Prices emerge from temporary equilibrium between supply and demand, so agents' decisions feed back into the price process. The model links this feedback between trading behavior and price fluctuations.

The authors argue that this mechanism can explain implied volatility skew and smile observed in actual markets. The document offers a conceptual explanation rather than details of a calibration or empirical test. It does not specify assets, data, or whether the model's implications can be translated into a trading strategy.

Key ideas

  • Market prices are modeled as arising from temporary equilibrium between supply and demand.
  • Prospect agents adjust their actions in response to gains and losses.
  • Agents’ trading behavior feeds back into the price process and its fluctuations.
  • The proposed feedback mechanism is used to explain implied volatility skew and smile.

Tags

OptionsVolatilityMarket microstructure
Full text
# Prospect Agents and the Feedback Effect on Price Fluctuations


# Prospect Agents and the Feedback Effect on Price Fluctuations









A microeconomic approach is proposed to derive the fluctuations of risky asset price, where the market participants are modeled as prospect trading agents. As asset price is generated by the temporary equilibrium between demand and supply, the agents' trading behaviors can affect the price process in turn, which is called the feedback effect. The prospect agents make actions based on their reactions to gains and losses, and as a consequence of the feedback effect, a relationship between the agents' trading behavior and the price fluctuations is constructed, which explains the implied volatility skew and smile observed in actual market.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.