An Adaptive Model of Asset Pricing and Wealth Dynamics with Heterogeneous Trading Strategies

ABSTRACT. This paper develops an adaptive model of asset price and wealth dy-namics in a nancial market with heterogeneous agents and examines the protability of momentum and contrarian trading strategies. In order to characterize asset prices, wealth dynamics and rational adaptiveness arising from the interaction of heteroge-neous agents with CRRA utility, an adaptive discrete time equilibrium model in terms of return and wealth proportions (among heterogeneous representative agents) is es-tablished. Taking trend followers and contrarians as the main heterogeneous agents in the model, the protability of momentum and contrarian trading strategies is an-alyzed. Our results show the capability of the model to characterize some of the existing evidence on many of the anomalies observed in nancial markets, includ-ing the protability of momentum trading strategies over short time intervals and of contrarian trading strategies over long time intervals, rational adaptiveness of agents, overcondence and underreaction, overreaction and herd behavior, excess volatility, and volatility clustering