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News-Driven Expectations and Volatility Clustering

Economic Science Institute, Chapman University, 1 University Drive, Orange, CA 92866, USA
J. Risk Financial Manag. 2020, 13(1), 17; https://doi.org/10.3390/jrfm13010017
Received: 27 December 2019 / Revised: 14 January 2020 / Accepted: 16 January 2020 / Published: 20 January 2020
Financial volatility obeys two fascinating empirical regularities that apply to various assets, on various markets, and on various time scales: it is fat-tailed (more precisely power-law distributed) and it tends to be clustered in time. Many interesting models have been proposed to account for these regularities, notably agent-based models, which mimic the two empirical laws through a complex mix of nonlinear mechanisms such as traders switching between trading strategies in highly nonlinear way. This paper explains the two regularities simply in terms of traders’ attitudes towards news, an explanation that follows from the very traditional dichotomy of financial market participants, investors versus speculators, whose behaviors are reduced to their simplest forms. Long-run investors’ valuations of an asset are assumed to follow a news-driven random walk, thus capturing the investors’ persistent, long memory of fundamental news. Short-term speculators’ anticipated returns, on the other hand, are assumed to follow a news-driven autoregressive process, capturing their shorter memory of fundamental news, and, by the same token, the feedback intrinsic to the short-sighted, trend-following (or herding) mindset of speculators. These simple, linear models of traders’ expectations explain the two financial regularities in a generic and robust way. Rational expectations, the dominant model of traders’ expectations, is not assumed here, owing to the famous no-speculation, no-trade results. View Full-Text
Keywords: volatility clustering; power law; trend following; efficient market hypothesis; liquidity volatility clustering; power law; trend following; efficient market hypothesis; liquidity
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MDPI and ACS Style

Inoua, S.M. News-Driven Expectations and Volatility Clustering. J. Risk Financial Manag. 2020, 13, 17.

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