Heterogeneous Beliefs and Destabilization of Financial Markets

I develop a five-type heterogeneous agent model that provides a framework to empirically investigate the financial market described by De Long et al. (1990a,b). I show that it is feasible to construct a heterogeneous agent model where arbitrageurs can engage in momentum trading and noise traders leave the market due to short-sale constraints. The empirical results provide evidence that supports the theoretical framework by De Long et al. (1990a,b) in various respects. The analysis includes both simulation and estimation and the results show that arbitrageurs who are herding can have either a dampening or a destabilizing effect on asset prices. I find that a higher fraction of arbitrageurs that engage in momentum trading results in a higher price deviation from fundamental value. Similarly, a higher fraction of noise trader demand increases the misspricing and is associated with a more unstable market.