Physic of Socioeconomic System (Cours Polytechnique)

OMI 446: Physics of Socioeconomic
Systems
MICHAEL BENZAQUEN1
ENSAE IP Paris – 1st year
February 14, 2020
www.econophysiX.com
michael.benzaquen@polytechnique.edu
ii
Contents
Foreword 1
1 Choice theory and decision rules 3

1.1 The logit rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1.1 What is it? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1.2 How should I interpret it? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.3 Is it justified? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2 Master equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3 Detailed balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2 Imitation of the peers and other interactions 7

2.1 Collective behaviour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1.1 Statistical physics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1.2 Power laws, scale invariance and universality . . . . . . . . . . . . . . . . . . . . . . 9
2.2 Mimicry and opinion changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2.1 The random field Ising model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2.2 Collective decision making with heterogeneities . . . . . . . . . . . . . . . . . . . . . 11
2.2.3 The limits of copy-cat strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.2.4 Kirman’s ants, herding and switching . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.3 Segregation, Schelling and the invisible hand . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3 Imitation of the past 17

3.1 Memory effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.1.1 Estimation error and learning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.1.2 Habit formation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3.2 Self-fulfilling prophecies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3.3 Feedback and instabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
3.3.1 Langevin dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
3.3.2 Excess volatility, bubbles and crashes . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
4 Fish markets 21
4.1 Why fish markets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4.2 The Marseille fish market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
4.3 Trading relationships and loyalty formation . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
4.3.1 A simple model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
4.3.2 Mean Field Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
4.3.3 Beyond Mean Field . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
4.3.4 Heterogeneities and real data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.4 The impact of market organisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.4.1 The Ancona fish market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4.4.2 Similarities and differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
iii
iv CONTENTS
5 Financial markets 27
5.1 How do prices change? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
5.1.1 Bachelier’s Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
5.1.2 Central Limit Theorem and rare events . . . . . . . . . . . . . . . . . . . . . . . . . . 28
5.1.3 Absolute or relative price changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
5.1.4 Fat tails . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
5.1.5 Heteroskedasticity and volatility dynamics . . . . . . . . . . . . . . . . . . . . . . . . 29
5.1.6 Leverage effect and skewness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
5.2 Why do prices change? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
5.2.1 The Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
5.2.2 Empirical data and "puzzles" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
5.2.3 Continuous double auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
5.2.4 Liquidity and market impact . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
5.2.5 Short-term mean reversion, trend and value . . . . . . . . . . . . . . . . . . . . . . . 33
5.2.6 Paradigm shifting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
5.3 Agent-based models for price changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
5.3.1 Herding and percolation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
5.3.2 The minority game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5.4 Dimensional analysis in finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.4.1 Vaschy-Bukingham π-theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.4.2 An example in physics: The ideal gas law . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.4.3 An example in finance: The ideal market law . . . . . . . . . . . . . . . . . . . . . . . 38
5.4.4 Empirical evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Foreword
The inadequacy of the models used to describe socioeconomic systems played an important role in
some of the the worst financial and economic crises, with significant impact on people’s lives. From
a physicist’s perspective, understanding the aggregate dynamics of socioeconomic systems is a truly
fascinating and challenging problem (take e.g. the price formation mechanisms – namely how markets
absorb and process information of thousands of individual agents to come up to a "fair" price). For-
tunately, these days such systems (financial markets in particular) provide enormous amounts of data
that can be used to test scientific theories at levels of precision comparable to those achieved in physical
sciences.
This course presents the approach adopted by physicists to analyze and model socioeconomic sys-
tems. Rather than sticking to a rigorous mathematical formalism, we will seek to foster critical thinking
and develop intuition on the "mechanics" of such complex systems, the orders of magnitude, and certain
open problems. By the end of this course, students should be able to:
• Answer simple questions on the subject of this course (without course notes).
• Conduct logical reasoning to answer modeling problems (ABM).
• Carry out simple calculations similar to those presented in class and during the tutorials.
The content of this course is mainly inspired by references [1, 2].
1
2 FOREWORD
1
Choice theory and decision rules
In this Chapter we introduce some important ideas on classical choice theory and discuss its grounds.
1.1 The logit rule
1.1.1 What is it?
Classical choice theory assumes that the probability pα to choose alternative α in a set A of different
possibilities is given by the logit rule or quantal response [3]:
1 βuα X
pα = e , with Z= eβuγ , (1.1)
Z γ∈A
where uα denotes the utility of alternative α,1 and β is a parameter that allows to interpolate between
deterministic utility maximization (β → ∞) and equiprobable choices or full indifference (β = 0).2
Indeed, in the β = 0 limit one obtains ∀α, pα = 1/N with N = card(A ), regardless of the utilities. In
the β → ∞ limit, one obtains that all pα are zero except for pαmax = 1 where αmax = argmaxα∈A (uα ). In
analogy with statistical physics, β := 1/T is often called inverse temperature. In the 2D case A = {1, 2}
one has:
eβu1 eβ∆u 1 β∆u

p1 = = = 1 + tanh , with ∆u = u1 − u2 , (1.2)
eβu1 + eβu2 1 + eβ∆u 2 2
and p2 = 1 − p1 . See Fig. 1.1 for an illustration of the limit cases discussed above.
Figure 1.1: Probability p1 as function ∆u = u1 −u2 for three different values of the temperature T = 1/β.
1
Utility maximisation in economics is tantamount to energy minimisation in physics; one might define an energy scale for
the alternatives as eγ = −uγ .
2
There is no reason to think that the inverse temperature β should be the same for all agents. Some may be more/less
rational than others, such there could be a distribution of β’s. This however falls beyond the scope of this course.
3
4 1. CHOICE THEORY AND DECISION RULES
1.1.2 How should I interpret it?

There are actually two possible interpretations of the logit rule.
• The first one is static: any given agent i always makes the same choice, based on the maximisation
of his perceived utility ûαi = uα + εαi where the εαi are random variables fixed in time. Agents’
estimates of the utilities are noisy [4]; such noise varies across agents because of irrational effects
such as illusions and intuitions, or cognitive limitations. In such a case and for a large population,
pα is the fraction of agents having made choice α.
• The second one is dynamic: agents continuously flip between different alternatives, because of
a truly time evolving context or environment, or just because people change their minds all the
time even when confronted to the very same information. The perceived utility now writes ûαi =
uα + εαi (t) where εαi (t) are time dependent random variables. Here, pα is the probability for a
given agent to choose α at a given instant in time.
The second interpretation is more sound, especially when considering interacting agents as we shall
see in Chapter 2.
1.1.3 Is it justified?
Well, not really. Typical justifications found in the literature are given below.
• Axiomatic [3].
• If one considers that the εαi are iid random variables distributed according to a Gumbel law
(double-exponential), it is possible to show that the probability is indeed given by Eq. (1.1) [5].
The deep reason for choosing a Gumbel distribution remains rather elusive.
• Rational choice theory goes with the assumption that the agent considers all available choices
presented to him, weighs their utilities against one another, and then makes his choice. A num-
ber of criticisms to this view of human behaviour have emerged, with e.g. Simon [6] as a key
figure. Simon highlighted that individuals may be “satisfiers” rather than pure optimisers, in
the sense that there is both a computational cost and a cognitive bias related to considering the
universe of available choices. This led to the idea of bounded rationality as a way to model real
agents [7–10]. Also Schwartz [11] observed that while standard economic theory advocates for
the largest number of options possible, “more can be less” due to both cognitive and processing
limitations. In other words, agents maximizing their utility take into
P account the information cost
(or the entropy) which according to Shannon [12] writes S = − α pα log pα . In this exploration-
exploitation setting, maximizing F = U + T S with U = α pα uα naturally yields pα ∼ exp(βuα ),
P
see [13]. Although clearly more sound than the previous argument, there are no solid behavioral
grounds supporting it either.
• The ultimate (and honest) argument is that the logit rule is mathematically very convenient.
Indeed, it is non other than the Boltzmann-Gibbs distribution used in statistical physics for which
a number of analytical results are known.
1.2 Master equation

Provided there is no learning or feedback inducing some systematic evolution of the utilities, one can
think of a dynamical model of decisions as the following Markov chain. At each time step, agent i
reviews his alternatives γ 6= α sequentially. He decides to go for alternative γ with probability equal
to the probability that ûγi > ûαi , equivalently εγi (t) − εαi (t) > uα − uγ . In other words, alternative γ is
adopted with probability R> (uα − uγ ) where R> is the complementary cumulative distribution function
(ccdf) of noise differences, see Fig. 1.2.3
R∞
3
Denoting r(∆ε) the probability distribution function of noise difference, the ccdf writes R> (∆ε) = ∆ε
r(x)dx.
1.3. DETAILED BALANCE 5
Figure 1.2: Probability distribution function (pdf) of noise differences ∆ε and corresponding ccdf.
The Master equation is the equation for the evolution of the probabilities pα , which here thus writes
pα (t + 1) − pα (t) = dpα where:
X X
dpα = pγ (t)R> (uγ − uα ) − pα (t)R> (uα − uγ ) . (1.3)
γ6=α γ6=α
Note that the idea of locality would translate in the restriction of the sums to a subset of “neighbouring"
choices only.
1.3 Detailed balance

A sufficient condition for equilibrium (dpα = 0) is that each term in the sum of Eq. (1.3) disappears
independently:
pγ (t)R> (uγ − uα ) = pα (t)R> (uα − uγ ) , (1.4)
for all α, γ. Equation (1.4) is called the detailed balance; it translates the idea in statistical physics
that, at equilibrium, each microscopic process should be balanced by its reverse process (microscopic
reversibility) [14]. For Eq. (1.1) to be the equilibrium solution of Eq. (1.3), it thus suffices that
R> (−∆u) = eβ∆u R> (∆u). While the logistic function R> (∆u) = 1/[1+exp(β∆u)] is a natural solution,
there might very well be other possibilities. In particular, provided the distribution of noise differences
is symmetric, there exists a function F (∆u) = 1/2 − R> (∆u) such that F (0) = 0, F (−∆u) = −F (∆u)
and F 0 (0) ≥ 0. A Taylor expansion at small utility differences ∆u reveals:
log R> (−∆u)

= 4F 0 (0)∆u + O(∆u3 ) , (1.5)
log R> (∆u)
such that the detailed balance is always satisfied to first order with β = 4F 0 (0),4 but may be violated
for higher orders in utility differences.
Very little is known about detailed-balance-violating models. In statistical physics this question is
relevant for the dynamics of out-of-equilibrium systems. But when it comes to the decisions of people,
it is a highly relevant question even for equilibrium systems since there are no solid grounds to support
the detailed balance (and the logit rule). In all the following we will assume the logit rule as a sound
and simple model for decision making, but one should always remain critical and refrain from drawing
quantitative conclusions.
4
Interestingly enough, this argument allows to relate the temperature to the distribution of noise differences. If r(∆ε) is
Gaussian with standard deviation σ, one finds β ∼ 1/σ.
6 1. CHOICE THEORY AND DECISION RULES
2
Imitation of the peers and other

interactions
In this Chapter we provide a few instructive toy examples or toy models to help develop an intuition
about the possible effects of interactions and heterogeneities in complex socioeconomic systems.
2.1 Collective behaviour

2.1.1 Statistical physics
Statistical physics’ very raison d’être is to bridge the gap between the microscopic world and the macro-
scopic laws of nature. It provides an intellectual scheme and tools to describe the collective behaviour
of large systems of interacting particles, which can be very diverse objects from molecules and spins to
information bits or individuals in a crowd, or market participants. As put by Anderson in his exquisite
paper More is different [15]:
“ The constructionist hypothesis breaks down when confronted with the twin difficulties of
scale and complexity. The behavior of large and complex aggregates of elementary particles, it
turns out, is not to be understood in terms of a simple extrapolation of the properties of a few
particles. Instead, at each level of complexity entirely new properties appear, and the understand-
ing of the new behaviors requires research which I think is as fundamental in its nature as any
other.”
– Philip W. Anderson
Let us also mention that while such ideas were mainly developed by statistical physicists, others
had similar ideas. For example, as Poincaré commented on Bachelier’s thesis:
“ When men are in close touch with each other, they no longer decide independently of each
other, they each react to the others. Multiple causes come into play which trouble them and pull
them from side to side, but there is one thing that these influences cannot destroy and that is their
tendency to behave like Panurges sheep.”
– Henri Poincaré
Nature counts many examples of collective behaviour, from the dynamics of bird flocks or fish
schools to the synchronisation of fireflies (see [16] for a great holiday reading). Interactions are key
in understanding collective phenomena. For example, by no means could anyone pretend to account
for the complex dynamics of a bird flock by simply extrapolating the behaviour of one bird. Only
interactions can explain how over a thousand birds can change direction in a fraction of a second,
without having a leader giving directions. Interactions are responsible for the nonlinear amplification of
local fluctuations (avalanches). Further, it appears that the features of the individual may be inessential
to understand aggregate behaviour. Indeed, while a bird and a fish are two quite different specimens of
the animal world, bird flocks and fish schools display numerous similarities. Human systems naturally
7
8 2. IMITATION OF THE PEERS AND OTHER INTERACTIONS
Figure 2.1: Examples of collective phenomena in the animal world and human systems.
display collective behaviour as well, for the better or for the worse, see Fig. 2.1. Other examples are
clapping, fads and fashion, mass panics, vaccination campaigns, protests, or stock market crashes.
2.2. MIMICRY AND OPINION CHANGES 9
2.1.2 Power laws, scale invariance and universality

Physicists are quite keen on power laws as they are most often the signature of collective, complex and
fascinating phenomena.
Power laws are interesting because they are scale invariant functions.1 This means that, contrary
to e.g. exponential functions, systems described by power laws have no characteristic length scales or
timescales. Many examples can be found in the physics of phase transitions. At the critical temperature
of the paramagnetic-ferromagnetic phase transition, Weiss magnetic domains become scale invariant.
So do the fluctuations of the interface at the critical point of the liquid-gas phase transition. Of particular
interest to our purpose is the percolation phase transition, see below. Fluid turbulence displays a
number of power laws; in particular the statistics of the velocity field in a turbulent flow are often
made of scale invariant power laws, independent of the fluid’s nature, the geometry of the flow and
even the injected energy. Power laws are also very present in finance (probability distribution of stock
market returns, correlations of volatility or of the order flow, volatility decay after endogenous shocks),
and economics (probability distribution of firm sizes, income, wealth etc.), see [17] for a comprehensive
review. Such power laws are most often universal, that is independent of the microscopic details of the
system at hand, the time period, geographically, etc.
All this indicates that socioeconomic systems can probably benefit from the sort of analysis and
modelling conducted in physics to understand complex collective systems. In a nutshell, it amounts
to modelling the system at the microscopic level with its interactions and heterogeneities, most of-
ten through agent-based modelling (ABM), and carefully scaling up to the aggregate level where the
generic power laws arise. One important remark is in order here: this approach goes against the whole
representative agent idea which nips in the bud all heterogeneities, often essential to account for the
phenomena at hand, see Kirman’s magnificent paper entitled Whom or what does the representative
individual represent? [18]. Actually, simplifying the world to representative agents poses a real dimen-
sionality issue: while there is only one way to be the same, there are an infinity number of ways to be
different.
2.2 Mimicry and opinion changes

Below, we present four insightful toy models to illustrate the effects of interactions in collective decision
making.
2.2.1 The random field Ising model

The random field Ising model (RFIM) was introduced in the 90’s to model hysteresis loops in disordered
magnets [19]. Such magnets, called spins, flip collectively in response to a quasi-steady external solici-
tation. Depending on the parameters, the flips may take place smoothly, or be organized in intermittent
bursts, or avalanches, leading to a specific acoustic pattern called Barkhausen noise. Because the model
is so generic, it has been used to account for many other physical situations, such as earthquakes,
fracture in disordered materials, failures in power grids, etc.
Here we present its application to socio-economic systems [20], and in particular to binary decision
situations under both social pressure and the influence of some global information. The ingredients of
the model are as follows:
• Consider a large number N of agents who must make a binary choice (e.g. to buy or to sell, to
trust or not to trust, to vote yes or no, to cheat or not to cheat, to evade tax or not, to clap or to
stop clapping, to attend or not to attend a seminar, to join or not to join a riot, etc.).
• The outcome of agent i’s choice is denoted by si ∈ {−1, +1}.
f (x)

1
A function f is said to be scale invariant if and only if there exists a function g such that for all x, y, f ( y) =g x
y . One
can easily show that the only scale invariant functions are power laws.
• The incentive ∆ui of agent i to choose +1 over −1 is given by:2

N
X
∆ui (t) = f i + h(t) + Ji j s j (t − 1) , (2.1)
j=1
encoding that the decision of agent i depends on three distinct factors:
1. The personal inclination, which we take to be time independent and which is measured by
f i ∈ R with distribution ρ( f ). Large positive (resp. negative) f indicates a strong a priori
tendency to decide si = +1 (resp. si = −1).
2. Public information, affecting all agents equally, such as objective information on the scope
of the vote, the price of the product agents want to buy, the advance of technology, etc. The
influence of this exogenous signal is measured by the incentive field h(t) ∈ R.
3. Social pressure or imitation effects. Each agent i is influenced by the previous decision made
by a certain number of other agents j. The influence of j on i is measured by the connectivity
matrix Ji j . If Ji j > 0, the decision of agent j to e.g. buy reinforces the attractiveness of the
product for agent i, who is now more likely to buy. It is natural to expect that this reinforcing
effect, if strong enough, can lead to an unstable feedback loop.
• Agents decide according to the logit rule (see Chapter 1). In particular:
eβ∆ui
P(si = +1|∆ui ) = , P(si = −1|∆ui ) = 1 − P(si = +1|∆ui ) , (2.2)
1 + eβ∆ui
where we recall that β quantifies the level of rationality in the decision process, analogous to
the inverse temperature in physics. When β → 0 incentives play no role and the choice is totally
random/unbiased, whereas β → ∞ corresponds to deterministic behaviour.
We focus on the mean-field case where Ji j := J/N for all i, j,3 and f i = f = 0 for all i. Note that thisPdoes
−1
not mean that each agent consults all the others, but rather that the average opinion m := N i si ,
or e.g. the total demand, is public information and influences the behaviour of each individual agent
equally.4 Defining the average incentive ∆u := N −1 i ∆ui and the fraction φ = N+ /N of agent
P
choosing +1, one can easily show that:

m(t) = 2φ(t) − 1 , and ∆u(t) = h(t) + J 2φ(t − 1) − 1 . (2.3)
Using Eqs. (2.2) and denoting ζ = eβ∆u yields the following updating rules:
ζ 1
P(N+ → N+ + 1) = (1 − φ) , P(N+ → N+ − 1) = φ , (2.4)
1+ζ 1+ζ
which naturally lead to the following evolution equation: 〈N+ 〉 t+1 = 〈N+ 〉 t + 1 × P(N+ → N+ + 1) − 1 ×
P(N+ → N+ − 1) + 0 × P(N+ → N+ ) that is:
ζ
d〈N+ 〉 = −φ. (2.5)
1+ζ
The equilibrium state(s) of the system are such that d〈N+ 〉 = 0 which yields:
ζ? ?
φ? = , with ζ? = eβ[h+J(2φ −1)]
. (2.6)
1 + ζ?
Noting that m? = 2φ ? − 1 yields the well known Curie-Weiss (self-consistent) equation:
β
m? = tanh 2 (h + J m? ) .

(2.7)
The incentive ∆ui is the difference between the utilities choices +1 and −1.
2
3
Local networks effects relevant in the socio-economic context can be addressed, e.g. taking Ji j to be a regular tree or a
random graph, but falls beyond the scope of this course.
4
In the case of financial markets, the price change itself can be seen as an indicator of the aggregate demand.
The solutions of Eq. (2.7) are well known (see Fig. 2.2). When h = 0, there is a critical value βc = 2/J
separating a high temperature regime β < βc where agents shift randomly between the two choices,
with φ ? = 1/2; this is the paramagnetic phase. A spontaneous polarization (symmetry-breaking) of the
population occurs in the low temperature regime β > βc , that is φ ? 6= 1/2; this is the ferromagnetic
phase.5 When h 6= 0, one of the two equilibria becomes exponentially more probable than the other.
m?
> c
< c
Figure 2.2: Average opinion (or aggregate demand, or overall trust etc.) as a function of the external
incentive field in the high and low temperature limits.
To summarise the results let us consider the following gedankenexperiment. Suppose that one starts
at t = 0 from a euphoric state (e.g. confidence in economic growth), where h J, such that φ ? = 1
(everybody wants to buy). As confidence is smoothly decreased, the question is: will sell orders appear
progressively, or will there be a sudden panic where a large fraction of agents want to sell? One finds
that for small enough influence, the average opinion varies continuously (until φ ? = 0 for h −J),
whereas for strong imitation discontinuity appears around a crash time, when a finite fraction of the
population simultaneously change opinion. Empirical evidence of such nonlinear opinion shifts can be
found in the adoption of cell phones in different countries in the 90s [21], the drop of birth rates by
the end of the glorious thirty [22], crime statistics in different US states [23], or the way clapping dies
out at the end of music concerts [21].
For β close to βc , one finds that opinion swings (e.g. sell orders) organise as avalanches of various
sizes, distributed as a power-law with an exponential cut-off which disappears as β → βc . The power
law distribution indicates that most avalanches are small, but some may involve an extremely large
number of individuals, without any particularly large change of external conditions. In this framework,
it is easy to understand that, provided the external confidence field h(t) fluctuates around zero, bursts
of activity and power-laws (e.g. in the distribution of returns) are natural outcomes. In other words,
a slowly oscillating h(t) leads to a succession of bull and bear markets, with a strongly non-Gaussian,
intermittent behaviour.
2.2.2 Collective decision making with heterogeneities

Aside from his famous segregation model (see Section 2.3), Thomas Schelling introduced another
model which attracted a lot of attention. It is a model for collective decision making with hetero-
geneous agents having to choose between two options (e.g. joining a riot or not, attending a seminar
or not, trading or not, etc.) under the influence of the number of people who made a certain decision at
the previous time step. It is an interesting setting to understand some possible nontrivial implications
of heterogeneity in collective decision making, such as thresholds. The ingredients of the model are as
follows.
• Consider a large number N of agents who must make a binary choice, say join a riot or not.
• Call Nt+ the number of agents deciding to join at time t and φ t = Nt+ /N .
• Each agent i makes his mind according to his conformity threshold ci ∈ [0, 1], heterogeneous
across agents and distributed according to ρ(c).
p (β → βc ) allows to
5
Using the Taylor expansion of the tanh function in Eq. (2.7) in the vicinity of the critical point
determine the critical exponents of this phase transition. In particular for β ¦ βc one finds: |m? | ∼ β − βc .
• If the number of agents Nt+ exceeds N (1 − ci ), then agent i joins at t + 1.

+
= i 1Nt+ >N (1−ci ) or equivalently
P
In mathematical terms the last point translates into Nt+1
1X 1X
φ t+1 = 1φ t >(1−ci ) = 1ci >1−φ t . (2.8)
N i N i
In the continuous limit (large N ) this is

Z ∞
φ t+1 = ρ(c)dc = 1 − P< (1 − φ t ) . (2.9)
1−φ t
R∞
where we have introduced P> (u) = 1 − P< (u) := u ρ(v)dv. The equilibrium fraction of adopters φ ?
is such that φ ? = 1 − P< (1 − φ ? ). If the only solutions of this equation are the trivial φ ? = 0 and φ ? = 1
(see left panel of Fig. 2.3), then any small initial adoption will induce the whole population to adopt
the same decision. This corresponds to a situation in which ρ(c) is a monotonous function. If on the
other hand some non trivial solution 0 < φ ? < 1 exists, then the fraction of adopters must exceed a
certain tipping point to induce full adoption (see right panel of Fig. 2.3). This is the case if ρ(c) is a
non-monotonous function, say a Gaussian distribution centred at x = 1/2.
Figure 2.3: Fixed points of the 1st Shelling model.
2.2.3 The limits of copy-cat strategies

The Marsili & Curty forecasting game [24] provides a very simple framework to understand why there is
some value in following the trend (herding or crowding), and why beyond a certain number of copy-cats
such a game becomes quite dangerous.The ingredients of this model are as follows.
• Consider a large number N of agents who must make a binary choice.

• A fraction z of the population is made of fundamentalists who process information to make a
choice. They see right with probability p > 1/2 (encoding value in objective information).
• A fraction 1 − z of the population is lazy, made of followers who merely observe the action of
others to make up their mind.
• At each time step t, one of the lazy agent adopts the majority opinion at time t − 1 among a
group of m agents randomly chosen (including a priori both followers and fundamentalists). The
choices of the followers are initialised with equal probability and we assume m odd to avoid
draws.
• We denote by q t (resp. π t ) the probability that a follower (resp. an agent chosen at random)
makes the right choice at time t. We repeat this process until it converges: q t , π t → q, π.
An equal-time equation can be easily obtained by noting that agents are either fundamentalists or
followers, such that:
π t = z p + (1 − z)q t . (2.10)
A dynamical equation can be obtained by noting that the probability that a follower sees right at time
t + 1 is equal to the probability that the majority among m saw right at time t, which in turn equal to
the probability that at least (m + 1)/2 agents saw right at time t, such that:
m
X
` `
q t+1 = Cm π t (1 − π t )m−` . (2.11)
`=(m+1)/2
Combining Eqs. (2.10) and (2.11) yields a dynamical equation of the form:
q t+1 = Fz (q t ) , (2.12)
from which the fixed points q? (z), π? (z) can be computed, see Fig. 2.4.
Figure 2.4: Fixed points of the Marsili & Curty game.
• For z large, there is only one attractive fixed point q? = q> ≥ p. Followers actually increase
their probability of being right, herding is efficient as it yields more accurate predictions than
information seeking. Further, the performance of followers increases with their number! This
a priori counterintuitive result comes from the fact that while fundamentalists do not interact,
followers benefit from the observation of aggregate behavior. Herders use the information of
other herders who have themselves a higher performance than information forecasters.
• However, below a certain critical point zc , two additional solutions appear, one stable q< < 1/2
and one unstable. The upper solution q> keeps increasing as z decreases, until it decreases
abruptly towards 1/2 at z = 0. The lower solution q< is always very bad: there is a substantial
probability that the initial condition will drive the system towards q< , i.e. the probability to be
right is actually lower than a fair coin toss. If herders are trapped in the bad outcome, adding
more herders will only self-reinforce the effect, by that making things even worse.
Quite naturally, the next step is to allow agents to choose whether to be followers or fundamental-
ists, that is allowing for z to depend on time: z → z t . We consider selfish agents following game theory
and aiming at reaching a correct forecast. Further, given that information processing has a cost, as
long as 〈q〉 > p, agents will prefer switching from the fundamentalist strategy to the follower strategy
(z t ↓). Conversely, z t ↑ when 〈q〉 < p, and hence we expect that the population will self-organize to a
state z † in which that no agent has the incentive to change his strategy, that is 〈q(z † )〉 = p. The state
z † is called a Nash equilibrium. One can show that z † ∼ N −1/2 , see [24]. Most importantly, here, such
an equilibrium is the result of the simple dynamics of adaptive agents with limited rationality, in con-
trast with the standard interpretation with forward looking rational agents, who correctly anticipate
the behavior of others, and respond optimally given the rules of the game.
This model captures very well the balance between private information seeking and exploiting
information gathered by others (herding). When few agents herd, information aggregation is highly
efficient. Herding is actually the choice taken by nearly the whole population, setting the system in a
phase coexistence region (z † < zc ) where the population as a whole adopts either the right or the wrong
forecast. See [24] for the details and in particular the effects of including heterogeneity in the agents’
characteristics.
2.2.4 Kirman’s ants, herding and switching

Several decades ago entomologists were puzzled by the following observation. Ants, faced with two
identical and inexhaustible food sources, tend to concentrate more on one of them, but periodically
switch from one to the other. Such intermittent herding behavior is also observed in humans choosing
between equivalent restaurants [25], and in financial markets [26, 27]. As we shall see in Chapter 5,
herding can be responsible for large endogenous fluctuations.
Such asymmetric exploitation does not seem to correspond to the equilibrium of a representative
ant with rational expectations. The explanation is rather to be looked after in the interactions, or as
put by biologists: recruitment dynamics. Kirman proposed a simple and insightful model [28] based on
tandem recruitment to account for such behavior.
• Consider N ants and denote by n(t) ∈ [0, N ] the number of ants feeding on source A at time t.
• When two ants meet, the first one converts the other with probability 1 − δ.6
• Each ant can also change its mind spontaneously with probability ε.7
The probability pn+ for n → n + 1 can be computed as follows. Provided there are 1 − n ants feeding
on B, either one of them changes its mind with probability ε or she meets one of the n ants from A and
gets recruited with probability 1 − δ. The exact same reasoning can be held to compute the probability
pn− for n → n − 1. Mathematically this translates into:
n h n i
p n+ = 1− ε + (1 − δ) (2.13a)
N N − 1
n N −n
p n− = ε + (1 − δ) , (2.13b)
N N −1
the probability of n → n being given by 1 − pn+ − pn− . Two interesting limit cases can be addressed.
• In the ε = 1/2, δ = 1 (no interaction) case, the problem at hand is tantamount to the Ehrenfest
urn model or dog-flea model [29], proposed in the 1900’s to illustrate certain results of the emerg-
ing statistical mechanics theory. In this limit, n follows a binomial distribution at equilibrium
P(n) = CNn εn (1 − ε)N −n = CNn /2N .
• When δ = ε = 0, the first ant always adopts the position of the second, and since first/second are
drawn with equal probability, the n process is a martingale with absorption at n = 0 or n = N .
Indeed, once all the ants are at the same food source, nothing can convert them (ε = 0).8
In the general case and large N limit, one can show (see [28]) that there exists an order parameter
O = εN /(1−δ) such that for O < 1, the distribution is bimodal (corresponding to the situation observed
in the experiments), for O = 1 the distribution is uniform, and for O > 1 the distribution is unimodal,
see Fig. 2.5.9 Note that the interesting O < 1 regime can be obtained even for weakly persuasive agents
(δ ® 1) provided self-conversion ε is low enough.
6
Of course who “the first one" is, is unimportant since they could have been drawn in the other order with the same
probability.
7
In the framework of trading, ε can represent either exogenous news, or the replacement of the trader by another one.
8
The probability for absorption at n = N is simply given by n0 /N with n0 the number of ants feeding on A at t = 0.
9
In the O < 1 regime with δ = 2ε and N → ∞ limit one can prove that the distribution of the fraction x = n/N is given
by a symmetric Beta distribution P(x) ∼ x α−1 (1 − x)α−1 with α = εN .
2.3. SEGREGATION, SCHELLING AND THE INVISIBLE HAND 15
Figure 2.5: (Left) Switching behavior in the O < 1 regime. (Right) Ant population distributions for
three different value of the order parameter O = εN /(1 − δ).
When O > 1 the system fluctuates around n = N /2. When O < 1, while the average value of n is
also N /2, this value has little relevance since the system spends most of the time close to the extremes
n = 0, N , regularly switching from one to the other.10
The most important point is that in the O < 1 regime, none of the n states is, itself, an equilibrium.
While the system can spend a long time at n = 0, N (locally stationary) these states are by no means
equilibria. It is not a situation with multiple equilibria, all the states are always revisited, and there is
no convergence to any particular state. In other words, there is perpetual change, the system’s natural
endogenous dynamics is out of equilibrium.11 Most economic models focus on finding the equilibrium
to which the system will finally converge, and the system can only be knocked of its path by large
exogenous shocks. Yet, financial markets or even larger economies display a number of regular large
switches (correlations, mood of investors etc.) which do not seem to be always driven by exogenous
shocks. In the stylised setting presented here such switches are understood endogenously.
Several extensions of the model have been proposed. In particular, the version presented here does
not take into account the influence of the proximity of agents; but one can easily limit the scope of
possible encounters according to a given communication network Ji j (see RFIM model above).
2.3 Segregation, Schelling and the invisible hand

The 2nd Schelling model, or simply Schelling’s model [30], probably stands among the most important
models in social sciences.
Its original version was introduced in the end of the 1960’s to account for racial segregation in
American cities [30, 31]. It builds on the idea that agents’ satisfaction depends on the color of neigh-
boring agents. On a square lattice, each location i has at most 8 neighbors and one can define the
fraction of different agents as f i = Di /(Di + Si ) with Di (resp. Si ) the number of agents with a different
(resp. same) color as his. The agents’ satisfaction is a binary variable: the agent sitting on location i
is satisfied if the fraction f i is smaller than a certain threshold or tolerance level µ. At each time step
a randomly chosen agent considers moving to a vacant randomly chosen location j, and only does so
if f j < µ. Starting from a random configuration in which the agents are intimately mixed, different
regimes arise as function of the tolerance level µ, see e.g. [32]. For low tolerance, the dynamics is
rapidly frozen out of equilibrium in an unsatisfying mixed state, due to the fact that there are very few
“happy" sites one can move to. For intermediate tolerance, the system strongly segregates into two
homogeneous regions of different colors. For high tolerance the system is well mixed
The more modern version by Grauwin et al. [33] makes an interesting point. Its most important
result to our purpose is that interactions, even weak, can tear down Adam Smith’s Invisible Hand,12 in
the sense that utility maximisation at the individual scale can easily lead to highly suboptimal aggregate
10
Check https://rf.mokslasplius.lt/kirman-ants to play with the model.
11
The only thing that can be said is that there exists an equilibrium distribution.
12
As put by Adam Smith himself “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our
dinner, but from their regard to their own interest”.
states. Grauwin et al. considered a city divided in Q blocks or neighborhoods, each containing the same
number of houses. Agents’ satisfaction depends on the local density of the block they live in, with a
maximum at half-capacity ρmax = 1/2. The idea behind this choice is that agents prefer to live in
a partially filled neighborhood, too many people means having to queue up at the bakery, while too
little means no movie theatres or other leisure. Having agents choose to move according to the logit
rule, one can show that below a certain temperature, even a city with global density ρ0 = ρmax = 1/2
evolves towards a suboptimal equilibrium in which some blocks are left completely empty while others
are “too full” ρ > ρmax . In a recent study Jensen et al. [34] showed that a weak number of “altruist”
agents who maximize the global utility instead of their own is sufficient to restore an better aggregate
state with less empty blocks, by that making an even stronger point at invalidating Smith’s claim, see
Fig. 2.6.
Figure 2.6: From [34]. Evolution of a city (Q = 36), with selfish agents in red, altruists in yellow,
and empty sites in black. The situation in panel (b) is rapidly reached and roughly corresponds to
the equilibrium state without altruists. On longer timescales, altruists self-organise and concentrate to
stimulate moving by locally increasing the density of an empty neighborhood until the latter becomes
interesting enough for selfish agents to move.
3
Imitation of the past
In the previous Chapter we focused on the effects of interactions with the peers. In this brief Chapter,
we explore interactions with the past and their consequences.
3.1 Memory effects

As we have seen in Chapter 1, the key assumption in rational choice theory is that individuals set
their preferences according to an utility maximization principle. Each choice an individual can make
is assigned an utility, measuring the satisfaction it provides to the agent and frequently related to the
dispassionate forecast of a related payoff. As mentioned in Chapter 1, a number of criticisms to this
view exist [6–10], with in particular Kahneman [35, 36] who pointed at significant divergences between
economics and psychology in their assumptions of human behaviour, with a special emphasis on the
empirical evidence of the cognitive biases and the irrationality that guide individual behaviour.
“There is a steadily accumulating body of evidence that people, even in carefully set up ex-
perimental conditions, do not behave as they are supposed to do in theory. Heaven alone knows
what they do when they are let loose in the real world with all its distractions. (...) This said,
it seems reasonable to assume that people are inclined to move towards preferable situations in
some more limited sense and not to perversely choose outcomes which make them feel worse off.
But, one can think of many ways in which this could be expressed and one does not need to impose
the formal structure on preferences that we have become used to. People may use simple rules of
thumb and may learn what it is that makes them feel better off, they may have thresholds which
when attained, push them to react.”
– Alan Kirman
In this line of thought, an interesting idea is that the utility, or well-being, associated to a certain
decision may depend on our memory if it has already been made in the past, see e.g. [37].
3.1.1 Estimation error and learning

Realistically, the utility of a given choice cannot be thought of as time-independent. It is hard to know
how satisfying or “useful” choice α is without having tried it at least once (think of having to choose
among restaurants). The simplest way to model this effect is to write as in Chapter 1 the effective or
perceived utility as:
ûα (t) = uα + εα (t) , where now εα (t) = εα (0)e−Γα t . (3.1)
This encodes that the perceived utility is initially blurred by some estimation error that decays to zero
as the time standing by α grows; Γα−1 is the typical learning time. Note that this is somewhat tantamount
to having an inverse temperature β which increases with time.
17
18 3. IMITATION OF THE PAST
3.1.2 Habit formation

Another more interesting and intricate effect is habit formation. As agents explore and learn the utilities
with time, choices become more valuable only because they happened to be chosen. This can be related
to the formation of loyalty relationships with, say, your doctor (who knows best your medical history)
or your fishmonger (see Chapter 4), or because of risk aversion (another choice might be better, but
also much worse) or simple intellectual laziness.1 In order to model such effects in a simple way, one
can write:
Xt
ûα (t) = uα + φ(t − t 0 )1γ(t 0 )=α , (3.2)
t 0 =0
where the first term on the RHS is the intrinsic utility of choice α, while the second accounts for memory
effects. In other terms, the utility assigned to a choice is the sum of a “bare” component indicating a
choice’s objective worth plus a memory term affecting the utility of that choice whenever the individual
has picked it in the past (see Fig. 3.1).2 φ is a decaying memory kernel encoding that more recent
choices have a stronger effect, and γ(t) indicates the choice of the individual at time t.
Figure 3.1: Illustration of habit formation in an exploration-exploitation setup.
The sign of the kernel separates two different cases: φ < 0 indicates a situation where an individual
grows weary of his past choices, while φ > 0 corresponds to the case where an individual becomes
increasingly endeared with them. The former case leads to an exploration of all the choices. The latter
presents an interesting transition to a self-trapping regime when feedback is strong enough and memory
decays slowly enough. Memory effects hinder the exploration of all choices by the agent, and may even
cause him to leave the optimal choices unexplored: the agent remains stuck with an a priori suboptimal
choice (out of equilibirum), see [38].
3.2 Self-fulfilling prophecies

When both imitation of the past and imitation of the peers are present, they can reinforce each other
leading to self-fulfilling prophecies. More precisely, for the latter to arise one generally needs:
• A context of repeated decisions (such as investing in financial markets).

• A common temptation to compare the present situation with similar situations from the past
(people tend to think that what already happened is more likely to happen again).
• Some plausible story or narrative made up to explain the observed or imagined patterns.
Such a narrative then convinces more agents that the effect is real, and their resulting behaviour cre-
ates and reinforces the effect. In other terms, a large consensus among agents about the correlations
between a piece of information and the system’s reaction can be enough to establish these correlations.
Keynes called such a commonly shared representation of the world on which uncertain agents can rely
a convention, he noted that [39]:
1
Hotel and restaurant chains rely on this strong universal principle: people often tend to prefer things they know.
2
One may also think, in the physicist’s language, of an energy landscape (akin to minus the utility) where the energy of a
given site or configuration increases or decreases if the system has already visited that site.
3.3. FEEDBACK AND INSTABILITIES 19
“ A conventional valuation which is established as the outcome of the mass psychology of

a large number of ignorant individuals is liable to change violently as the result of a sudden
fluctuation of opinion due to factors which do not really make much difference.”
– John Maynard Keynes
A concrete example of self-fulfilling prophecy with a sudden change of convention is that of the
correlation between bond and stock markets as a function of time. The sign of this correlation has
switched many times in the past. The last one was took place during the 1997 Asian crisis. Before
1997, the correlation was positive, consistent with the belief that low long term interest rates should
favor stocks (since bonds move opposite to rates, an increase in bond prices should trigger an increase in
stock prices). But another story suddenly took over when a fall in stock markets triggered an increased
anxiety of the operators who sold their risky equity to replace it with non-risky government bonds
(Flight to Quality), which then became the dominant pattern.
3.3 Feedback and instabilities

For the sake of clarity, in this section we focus on the case of financial markets, but the ideas presented
here apply to a variety of different systems. We build on the idea that agents are sensitive to past price
moves. For many investors, past trends are incentives to buy or sell, as such moves might be reflection
of information that other investors possess. This is a rational strategy provided the other agents indeed
have extra information, but if not, it is clearly a mechanism for bubbles and excess volatility.
Feedback, or the action of the outputs of a system on its inputs (cause-and-effect loop), is well
understood in physics and engineering. Here, we analyse in a stylised setting the possible effects of
feedback in financial markets.
3.3.1 Langevin dynamics

We take that returns are proportional to imbalance φ t as:
φt
rt = , (3.3)
λ
where λ is a measure of market depth, and we suppose the following model for the evolution of im-
balance:
φ t+1 − φ t = ar t − br t2 − a0 r t − k(p t − pF ) + χξ t . (3.4)
The interpretation of each term in the right hand side of this equation is a follows.
• a > 0 accounts for trend following, past returns amplify the average propensity to buy or sell.
• b > 0 accounts for risk aversion. Negative returns have a larger effect than positive returns.
Indeed the two first terms can be re-written as (a − br t )r t such that it becomes clear that the
effective trend following effect increases when r t < 0. The term −br t2 also accounts for the effect
of short term volatility, the increase of which (apparent risk) is expected to decrease demand.
• a0 > 0 accounts for the market clearing mechanism. It is a stabilising term: price moves clear
orders and reduce imbalance.
• k > 0 accounts for mean-reversion towards a hypothetic fundamental value pF ; if the price wan-
ders too far above (resp. below) sell (resp. buy) orders will be generated.
• χ > 0 accounts for the sensitivity to random exogenous news ξ t , with 〈ξ t 〉 = 0, 〈ξ t ξ t 0 〉 =
2ς20 δ(t − t 0 ).
Combining Eqs. (3.3) and (3.4) and taking the continuous time limit r t ≈ u = ∂ t p, one obtains a
Langevin equation for the price velocity u of the form:
du ∂V u2 u3
= − + ξ̃ t , avec V (u) = κ(p t − pF )u + α +β , (3.5)
dt ∂u 2 3
20 3. IMITATION OF THE PAST
where we have introduced α = (a0 − a)/λ, β = b/λ, κ = k/λ, and ξ̃ t = χξ t /λ. The variable u
thus follows the dynamics of a damped fictitious particle evolving in a potential V (u) with a random
forcing ξ̃ t .
3.3.2 Excess volatility, bubbles and crashes

Here, we address different particular cases of increasing complexity (and interest), see Fig. 3.2.
• β = 0 – In this linear limit, the model reduces to a simple damped harmonic oscillator for the
price:
∂ t t p + α∂ t p + κ(p − pF ) = ξ̃ t .
For α < 0 the system is unstable (trend following is too strong), but for α > 0 one naturally
recovers stable dynamics. In all the following we assume that the system starts at p0 = pF .
• β > 0, α > 0 – Risk aversion is responsible for a local maximum at u = u? = −α/β < 0 and
a local minimum at u = 0 in the potential V (u) (see left panel of Fig. 3.2). A potential barrier
V ? := V (u? )−V (0) = αu∗ 2 /6 separates a metastable region around u = 0 from an unstable region
u < u? . Starting from p0 = pF the particle oscillates around u = 0 until an activated event driven
by ξ̃ t brings the particle to u? after which u → −∞, that is a crash induced by the amplification
of sell orders due to the risk aversion term. The typical time before the crash scales as exp(V ? /D)
with D ∝ (χ/λ)2 . Note that, here, a crash occurs due to a succession of unfavourable events
which add up to push the system below the edge, and not due to a single large event in particular.
Also note that, in practice, volatility feedback effects would increase fluctuations before the crash,
by that increasing D and thus lowering further the crash time.
Figure 3.2: Langevin potential V (u) for different values of the parameters.
• β > 0, α < 0 – Taking now trend following to be large compared with the stabilising effects
while keeping risk aversion yields a very interesting situation. Starting at t = 0 from p0 =
pF , the potential V (u) displays
a local maximum at u = 0 and a local minimum at u = u† =
−α/β with V = V (u ). In the beginning the particle oscillates around u† > 0 and the price
† †
increases linearly on average 〈p t − pF 〉 ∼ u† t with no economic justification whatsoever. This

is a speculative bubble, growth is self-sustained by the trend following effect. However, as time
passes the potential is modified (due to the increasing slope of the linear term κ(p t − pF )u) and
V † decreases accordingly (see right panel of Fig. 3.2). When the local minimum ceases to exist,
the bubble bursts, that is u† → −∞). The bubble lifetime t † is such that V † = u† t † which is
t † = −α/(4κ); as expected it increases with the amplitude of trend following and decreases with
that of mean reversion.
For a deeper analysis of destabilising feedback loops in financial markets, see our recent work on
endogenous liquidity crises [40].
4
Fish markets
Interactions and transactions most often take place in markets. While this might seem rather obvious
once said, it is surprising to see how more often than not markets are completely ignored in standard
models.
“ It is a peculiar fact that the literature on economics and economic history contains so little
discussion of the central institution that underlies neoclassical economics – the market.”
– Douglass North, 1977
4.1 Why fish markets?

A priori, one expects that different markets with different rules will display different features and yield
different outcomes. Stock markets, commodities markets, auction markets or art auctions to name a
few differ on many grounds. In this Chapter we focus on a simple market that exists since the dawn of
time: fish markets. Such markets are particularly adapted to academic analysis for several reasons.
• Transactions are public and available to us, in particular thanks to famous economist Alan Kir-
man [41–46] who thoroughly recorded them in different market places.
• Fish markets are simple notably because Fish is a perishable good and as a consequence there is
no stock management to deal with from one day to the next.
• They can be of different sorts, from peer-to-peer (P2P) such as Marseille, to centralised auctions
such as Ancona, Tokyo or Sydney. We can thus expect to learn something from the differences
and similarities of their outcomes.
As we shall see, perhaps surprisingly, from all the a priori disorder (several buyers and sellers with
different needs and prices), aggregate coordination emerges making the whole thing rather efficient.
Such aggregate behaviour displays a number a regularities, but the latter are clearly not the result of
isolated optimisers, they cannot be attributed to individual rationality, nor can they be accounted for
in the standard competitive framework. The aim of this Chapter is precisely to understand and model
aggregate coordination from the perspective of agents who learn from their past experience, rather
than optimise estimates of their future utilities.
“ What is the meaning of having preferences over future bundles of goods? How do I know
what my preferences will be when I arrive at a future point in time? In particular, if my experiences
influence my tastes how can I know what I will turn out to prefer. [...] There was an advertisement
for Guinness which said, ‘I don’t like Guinness. That’s why I have never tried it’. This seems
absurd to most people but is perfectly consistent with an economist’s view of preferences. Since
my preferences are well defined I do, in fact, know whether I like Guinness or not. Therefore there
is no reason for me to try it if I happen not to like it.”
– Alan Kirman
21
22 4. FISH MARKETS
4.2 The Marseille fish market

The Marseille fish market runs from 2 to 6am. A few hundreds of buyers interact with a few tens of
sellers to exchange a little bit more than a hundred kinds of fish. In contrast with auction markets,
prices are not publicly displayed in real time. There is no or little room for negotiation (take or leave
prices). Most importantly, the uncertainty about the quantity of available fish to buy at the beginning
of the day is very strong.
According to competitive equilibrium theory, and naively, one would expect that (i) after a short
relaxation time, the price of a given fish kind converges to some fair value, and (ii) prices decrease with
time in order to boost sales and reduce stock losses. Actually, neither is supported by empirical data.
Instead, there is no equilibrium price (large inter-agent and inter-temporal fluctuations persist). One
can nonetheless define an equilibrium distribution of prices which is stable at time scales larger than a
month. While difficult to measure, empirical data shows signs of learning (see supporting documents).
“ The habits and relationships that people have developed over time seem to correspond much
more to things learnt by the force of experience rather than to conscious calculation. ”
– Alan Kirman
4.3 Trading relationships and loyalty formation

4.3.1 A simple model
Following the work of Weisbuch and Kirman [47], we present a simple framework to understand the
impact of loyalty on the outcomes of markets such as Marseille. The main idea is that instead of
anticipating the future utility of choosing one seller or another, buyers develop affinities based on past
experience. Consider:
• N buyers i ∈ [1, N ] and M sellers j ∈ [1, M ].

• Buyer i updates his probability pi j (t) of choosing seller j according to a matrix of “preferences"
Ji j (t) ≥ 0, which depends on the accumulated profits resulting from i − j transactions until time
t. In particular, one can choose:
Ji j (t) = πi j (t) + (1 − γ)Ji j (t − 1) , (4.1)
where πi j (t) denotes the accumulated profits and γ is a discount factor accounting for finite
memory effects (the typical memory time scale is γ−1 ).
• We choose logit (or Boltzman) statistics (see Chapter 1):
1 β Ji j (t) X
pi j (t) = e , with Zi = eβ Jik (t) . (4.2)
Zi k
4.3.2 Mean Field Analysis

As in Chapter 2, we start by looking at the mean field approximation. Here, it amounts to replacing
random variables by the mean values πi j → 〈πi j 〉 and taking the continuous time limit:
∂ t Ji j = −γJi j + 〈πi j 〉 . (4.3)
We further note that 〈πi j 〉 relies on (i) seller j still having some quantity q j of fish on his stand, and (ii)
i visiting j, such that one can write:
〈πi j 〉 = P(q j > 0)pi j π̄ , (4.4)

4.3. TRADING RELATIONSHIPS AND LOYALTY FORMATION 23
with π̄ the average profit obtained from getting a quantity q j .1

Let us consider a simple case with only M = 2 sellers who always have fish available P(q j > 0) = 1.
Since in such a case buyers do not interact,2 we leave the i index out and focus on the one buyer having
to choose between the two sellers. If there is an equilibrium, it satisfies in particular ∂ t J1 = 0, which
combined with Eqs. (4.2), (4.3) and (4.4) yields γJ1 = π̄Z −1 eβ J1 , and symmetrically γJ2 = π̄Z −1 eβ J2
with Z = eβ J1 + eβ J2 . Defining ∆ = J1 − J2 , one obtains:
π̄ eβ∆ − 1 π̄ β∆

∆= = tanh . (4.5)
γ eβ∆ + 1 γ 2
As in the RFIM presented in Chapter 2, Eq. (4.5) can be solved graphically to obtain the results displayed
in Fig. 4.1.
Figure 4.1: Loyalty formation bifurcation and order parameter in the Weisbuch-Kirman model [47].
For β < βc := 2γ/π, there is only one solution ∆ = 0 corresponding to J1 = J2 = π/2γ, the
buyer visits both sellers with equal probability. For β > βc , the symmetric solution becomes unstable
and two nonzero symmetric solutions ∆± appear. In particular for β ¦ βc , ∆± ∼ ± β − βc . In this
p
regime, the buyer effectively prefers one of the two sellers and visits him more frequently, he becomes
loyal. Loyalty formation is more likely when memory is deep: βc ↓ when γ−1 ↑. Let us stress that
loyalty emerges spontaneously and is accompanied with symmetry breaking: none of the two sellers is
objectively better than the other.
4.3.3 Beyond Mean Field

Simulating the stochastic process described above for many buyers and sellers allows to obtain a large
amount of surrogate data to play with. A good order parameter to describe the state of the system,
inspired from [48], writes:
P 2
j Ji j
y i = P 2 , (4.6)
J
j ij
In the disorganised phase in which buyer i chooses among the M sellers with equal probability (∂ j Ji j =
0), one has yi = M Ji2j /M 2 Ji2j = 1/M . In the fully organised phase in which buyer i is loyal to seller k
only (Ji j ∼ δ jk ), one finds yi = 1. In particular 1/ yi represents the number of sellers visited by buyer i.
The simulated data is consistent with a transition from yi ≈ 1/M to 1 when β is increased beyond a
certain βc (see Fig. 4.1 and supporting documents).
Interestingly, fluctuations (e.g. of the number of visitors per seller) vanish in the fully organised
phase (β βc ), the buyer-seller network becomes deterministic. One might thus argue that the loyal
phase is “Pareto superior" given that the deterministic character of the interactions allows sellers to
estimate better the quantity of fish that they will sell, avoid unsold fish wasted at the end of the day,
which translates into higher profits than in the disorganised phase (β < βc ) for both customers and
sellers. This provides a nice example in which spontaneous aggregate coordination is beneficial.
1
In full generality π̄i j depends on both i and j, is the fish going to be sold at a mall’s food court or in fancy restaurant?
For the sake of simplicity, we here focus on a symmetric case π̄i j = π̄ for all i, j.
2
In the general case buyers interact since P(q j > 0) depends on other buyers having visited seller j before i.
24 4. FISH MARKETS
4.3.4 Heterogeneities and real data

So far we have assumed that all buyers are equally rational or irrational and have equal memory (same
γ and thus same βc ). In a real market, one expects highly heterogeneous agents, some being naturally
more loyal than others. This means that there are different βci = 2γi /π̄i ; average profit π̄i may vary
depending on what the buyer does with the product and γi may vary with the number of visits to the
market (every day, every week etc.).
Taking the simple case of a population with two sorts of agents βca βcb shows that, in the regime
βca< β < βcb , the presence of noisy b-agents does not prevent loyalty formation. This is not a trivial
result: one could have expected that sellers, less capable to properly anticipate their fish sales, could
end up out of fish when loyal customers arrive, by that degrading the loyalty relationship.
Actually, real data from the Marseille fish market is very well fitted by the simple case we just
discussed of a population with two sorts of agents. The fidelity histogram, namely the number of
buyers against the number of visited sellers, is bimodal with a large peak at x = 1 seller per buyer and
a second mode at x ≈ 4 to 5 sellers per customer (see supporting documents). Interestingly, there are
very few buyers in the partially loyal regime, people seem to be either loyal or “persistent explorers”
indicating that the loyalty transition is rather sharp.
As a conclusion, this very simple model does a good job at reproducing robust stylised facts in the
Marseille P2P fish market. Naturally, the model can be extended at will to account for more complexity
(e.g. sellers could propose different prices to different buyers).
4.4 The impact of market organisation

As mentioned above, other markets used different mechanisms. Here we explore how aggregate prop-
erties are affected by market organisation [46].
4.4.1 The Ancona fish market

The Ancona fish market, or MERITAN for ‘MERcato ITtico ANcona’, operates 4 days a week from 3:30
to 7:30am. It is organised as a Dutch auction (high initial price which decreases with time until a buyer
manifests himself). A few tends of boats present their fish to a few hundreds of buyers which results in
≈ 15 transaction per minute and 25 million euros a year.
In contrast with Marseille, buyers and sellers interact through a centralised system. The buyer-seller
network counts N + M links, instead of N × M . Another notable difference with Marseille is that here
everyone can see who buys what to whom.
4.4.2 Similarities and differences

Similar to Marseille, signs of learning are distinguishable with in particular a decay of price fluctuations
with time. The most interesting question is probably: does the central auction mechanism destroy the
loyalty arising from buyer-seller relationships? Data reveals that loyalty also emerges in Ancona; its
structure is nonetheless quite different.
To evaluate the degree of loyalty quantitatively, one can compute the Gini index which is a good
proxy of how much the purchases of a buyer are distributed among the different sellers. It is computed
as follows:
• The Lorentz curve is computed for one buyer and M sellers.

• The M sellers are ranked on the x-axis from the least visited to the most visited.
• The cumulative number of visits per seller ( y-axis) is plotted against x.
• The axes are normalised to [0, 1] and the Gini index G ∈ [0, 1] is computed as twice the area
separating the Lorentz curve and the bisectrix. If all sellers are equally visited by the buyer G = 0
(no loyalty), and if the buyer visited only one seller G = 1 (fully loyal).
4.4. THE IMPACT OF MARKET ORGANISATION 25
Looking at the pdf of Gini indices over all buyers reveal that loyalty also exists in Ancona (G ≈ 0.4 > 0),
but the distribution is unimodal, in contrast with Marseille where it is bimodal. One can argue that the
central auction mechanism erases the behavioral binarity.
Concluding remarks
Markets are a fundamental element of every economy. Fish markets show that the aggregate regularities
and coordination arise from the interactions between highly heterogeneous agents. While in Marseille
nothing prevents buyers to wander around and just pick the cheapest seller as would be required by the
standard model, this is not what happens. Most stylised facts revealed by data cannot be reasonably
accounted for with isolated representative agents; they can instead be reproduced in simple agent-
based models with memory but limited intelligence.3 Finally, differences in market organisation can
lead to differences in the aggregate results.
“ Aggregate regularity should not be considered as corresponding to individual rationality.
(...) The fact that we observe an aggregate result which conforms to the predictions of a particular
model is not enough to justify the conclusion that individuals are actually behaving as they are
assumed to do in that model.
– Alan Kirman
3
While the gap between micro and macro behavior is not straightforward, one does not need to take into account all the
complexity at the individual scale to understand aggregate behavior.
26 4. FISH MARKETS
5
Financial markets
Financial markets are among the most sophisticated and scrutinised markets. They are different from
the fish markets studied in the Chapter 4 on many grounds. Most importantly, modern financial markets
spit enormous amounts of data that can now be used to test scientific theories at levels of precision
inconceivable only a couple of decades ago.
5.1 How do prices change?

Here we present some important features and stylised facts on financial time series.
5.1.1 Bachelier’s Brownian motion

Bachelier’s thesis "Théorie de la spéculation" (1900) is often considered as the first serious attempt to
account for price dynamics. To note, it is a theory of Brownian Motion 5 years before Einstein’s [49]!
The idea of Bachelier is as follows:
1. Each transaction involves a buyer and a seller, which means that there must be as many people
who think the price will rise as people who think it shall decline. Therefore, price changes are
unpredictable, or in the modern language, price are Martingales.1
2. Further, if one considers that price returns at a given timescale, say daily, are non other than the
sum of a large number N of small price changes,
PN −1
p N − p0 = t=0 rt , with r t = p t+1 − p t ,
then, for large N , the Central Limit Theorem (CLT) ensures that daily price changes are Gaussian
random variables, and that prices thus follow Gaussian random walks.
While his first conclusion is rather accurate, the second is quite wrong as we shall see below. Note
however that such reasoning is quite remarkable for that time! On such grounds, Bachelier derives a
series of very interesting results such as Bachelier first law which states that the price variogram grows
linearly with time lag τ:
V (τ) := 〈(p t+τ − p t )2 〉 = Dτ , (5.1)
but also results on first passage times2 and option pricing (precursor of Black-Scholes).
1
A Martingale is a stochastic process x t satisfying 〈x t+s |{x 0 , x 1 , . . . , x t }〉 = 〈x t+s |x t 〉 = x t .
2
Calling τ1 the first passage time, one can show that for a Gaussian random walk the probability distribution of τ1 is given
by:
|∆x| ∆x 2

−3/2
P(τ1 ) = Æ exp − ∼ τ1 ,
4πDτ31 4Dτ1
such that the average first passage time diverges 〈τ1 〉 = ∞. The typical first passage time (∂τ1 P|τtyp = 0) reads τtyp = ∆x/6D.
27
28 5. FINANCIAL MARKETS
5.1.2 Central Limit Theorem and rare events

Let us now discuss further point 2. For the CLT to be applicable, several requirements need to be
met. The returns r t must be independent and identically distributed (iid) and have a finite variance
σ2 < ∞. While, as we shall see below, returns are not exactly iid, this is not the most problematic
point in Bachelier’s reasoning.3 In most markets (yet not all) return do have a finite variance, but it
should be noted that the CLT also applies beyond this constraint, only the aggregate distribution no
longer converges to a Gaussian but to a Levy stable law.
Most importantly, for the error to be negligible everywhere one needs N → ∞, or equivalently
here, continuous time.4 This is never the case in real life, and thus empirically the CLT only applies to a
central region of width w N , and nothing can be said for the tails of the distribution beyond this region
(see Fig. 5.1). If the return distribution is power law, say ρ(r) ∼ 1/|r| p
1+µ
with µ > 2 such that
p the
variance is still finite, the width of thepcentral region scales as w N ∼ N log N which is only log N
times wider than the natural width σ N . The probability to fall in the tail region decays slowly as
1/N µ/2−1 . In fact the tail behaviour of the aggregate distribution is the very same power-law as as that
of ρ(r). In other words, far away from the central Gaussian region, the power-law tail survives even
when N is very large.
Figure 5.1: Distribution of aggregate returns (N < ∞).
One should thus carefully refrain from invoking the central limit theorem to describe the proba-
bility of extreme events – in most cases, the error made in estimating their probabilities is orders of
magnitudes large.
5.1.3 Absolute or relative price changes

Are prices multiplicative or additive? Or in other words, are price changes proportional to prices? In
most cases, the order of magnitude of relative fluctuations (1-2% per day for stocks) are much more
stable in time and across assets than absolute price changes.5 This is in favour of a multiplicative price
process with relative returns, or equivalently an additive log-price process:
p t+1 − p t
x t := ≈ log p t+1 − log p t . (5.2)
pt
In addition, the price of stocks is rather arbitrary, as it depends on the number of stocks in circulation
and one may very well decide to split each share into n, thereby dividing their price by n, without a
priori changing any fundamental properties (splitting invariance or dilation symmetry). Another sym-
metry exists in foreign exchange (FX) markets. The idea is that there should be no distinction between
using the price π of currency A in units of B, or 1/π for currency B in units of A. Relative returns satisfy
such a property: x = δp/p = −δ(1/p)/(1/p).
3
Actually, in several cases the CLT holds much beyond the iid case.
4
Considering Gaussian iid returns in continuous time, one is left with the standard geometric Brownian motion model, well
established in mathematical finance since the 1960’s.
5
On a practical note, relative price changes are also more convenient since asset prices can span a few $ to a few M$.
5.1. HOW DO PRICES CHANGE? 29
Figure 5.2: Distribution of returns on different timescales (log-scale).
Notwithstanding, there are arguments in favour of an additive price process:
r t := p t+1 − p t . (5.3)
Indeed, the fact that price are discrete and quoted in ticks which are fixed fractions of dollars (e.g. 0.01$
for US Stocks) introduces a well-defined $-scale for price changes and breaks the dilation symmetry.
Other examples in favour of an additive price process are some contract for which the dilation argument
does not work, such as volatility, which is traded on option markets, and for which there is no reason
why volatility changes should be proportional to volatility itself.
5.1.4 Fat tails

In contradiction with textbook mathematical finance, the real price statistics of any kind of financial
asset (stocks, futures, currencies, interest rates, commodities etc.) are very far from Gaussian. Instead:
• The unconditional distributions of returns have fat power law tails. Recall that power law func-
tions are scale invariant, which here corresponds to micro-crashes of all sizes.
• The empirical probability distribution function of returns on short to medium timescales (from
a few minutes to a few days) is best fitted by a symmetric Student t-distribution, or simply the
t-distribution:
1+µ
1 Γ 2 aµ 1
P(x) := p µ ∼ , (5.4)
π Γ 2 (x 2 + a2 ) 21+µ
|x|1+µ

a2
with typically 3 < µ < 5. Its variance, given by σ2 = µ−2 , diverges as µ ↓ 2 from above.
• On longer timescales (months, years) the returns distribution becomes quite asymmetric. While
the CLT starts to kick (very slowly, see Section 5.1.2) for the positive tail, the negative remains very
fat. In other words, downward price jumps are on average larger than their upward counterparts.
• In extreme markets, one can have µ < 3 or even µ < 2 (e.g. MXN/$ rate) such that σ = ∞!
The daily returns of the MXN/$ rate are actually very well fitted by a pure Levy distribution with no
obvious truncation (µ ≈ 1.4). The case of short term interest rates is also of interest. The latter (say
3-month rates) are strongly correlated to the decision of central banks to increase or decrease the day-
to-day rate; kurtosis is rather high as a result of the short rate often not changing at all but sometimes
changing a lot.
5.1.5 Heteroskedasticity and volatility dynamics

As alluded to above, relative price returns x t are not exactly iid. While they are indeed quasi-uncorrelated:
〈x t x t 0 〉 ≈ σ2 δ(t − t 0 ) , (5.5)
for timescales above a few minutes and below a few days,6 or else statistical arbitrages would be
possible, one observes activity intermittency or volatility clustering, that is calm periods interspersed
with more agitated episodes of all sizes, see Fig. 5.3.
Figure 5.3: Intermittent or heteroskedastic signal.
Actually, the volatility is itself a dynamic variable evolving at short and long timescales (multiscale).
One says that price returns are heteroskedastic random variables, from ancient Greek hetero: different,
and skedasis: dispersion. A common model is given by:
x t = σt ξt , (5.6)
where the ξ t are centred iid random variables with unit variance encoding sign of returns and unpre-
dictability 〈ξ〉=0, while σ t is a positive random variable with fast and slow components. The squared
volatility variogram is given by:
Vσ2 (τ) := (σ2t+τ − σ2t )2 ≈ A − Bτ−ν , with ν ≈ 0.2 .

(5.7)
To validate such a scaling, one would need 1/ν ≈ 5 decades of data which is inaccessible. Actually, it is
difficult to be sure that Vσ2 (τ) converges to a finite value A at all. Multifractal models suggest instead:
Vlog σ (τ) := (log σ t+τ − log σ t )2 ≈ λ2 log τ .

(5.8)
Volatility appears to be marginally stationary as its long term average can hardly be defined. The very
nature of the volatility process is still a matter of debate (see [50] for recent insights) highlighting the
complexity of price change statistics.
5.1.6 Leverage effect and skewness

Financial time series break Time Reversal Symmetry (TRS). One can show that ξ t and σ t are not inde-
pendent and in particular:
• Negative past returns tend to increase future volatility,

• Positive past returns tend to lower future volatility,
• Past volatility is not informative of the sign of future returns (or else there would be trivial prof-
itable statistical arbitrage strategies).
This is the so-called leverage effect. Consistently, the response function 〈ξ t σ t+τ 〉 is negative for τ > 0,
and = 0 for τ < 0, see Fig.5.4. The leverage effect naturally has direct implications on the skewness of
the return distribution.
Real financial time series display a number of properties not accounted for within the geometric
(continuous time) Brownian motion standard framework. Accounting for of all these effects is of out-
most importance for risk control and derivatives pricing. Different assets differ in the value of their
higher cumulants (skewness, kurtosis); for this reason a description where the volatility is the only
parameter is bound to miss a great deal of reality.
6
At very high frequency price are mechanically mean reverting. At long timescales systematic inefficiencies exist (trend,
value).
5.2. WHY DO PRICES CHANGE? 31
Figure 5.4: Leverage effet. Plot of 〈ξ t σ t+τ 〉 as function of the lag τ.
5.2 Why do prices change?

In this section we confront two rather opposing views of prices in financial markets: price discovery and
price formation.
5.2.1 The Efficient Market Hypothesis

According to Eugene Fama’s Efficient Market Hypothesis (EMH) or Efficient Market Theory (EMT), asset
prices reflect all available information. This is the classical and dominant view (since the mid-1960s)
which can be coined price discovery, and which, as we shall see below, is poorly supported empirically.
It further relies on the idea that markets are at equilibrium (demand and supply are balanced), agents
have rational expectations etc.
“I can’t figure out why anyone invests in active management [...]. Since I think everything
is appropriately priced, my advice would be to avoid high fees. So you can forget about hedge
funds.”
– Eugene Fama
The market is seen as an objective measuring instrument which provides a reliable assessment p t
of the fundamental value vt of the exchanged assets.7 Consistently, in most Economics 101 textbooks
one shall find the following equation:
p t = E[vt |F t ] , (5.9)
with F t the common knowledge.8 Immediate consequences of the EMH are as follows.
• Prices can only change with the arrival of new exogenous information (e.g. new iPhone release,
discovery of a new gold mine, diplomatic crisis). As a results, price moves are unpredictable be-
cause news are, by definition, unpredictable. While consistent with Bachelier’s findings, nothing
says that the EMH it is the only possible explanation.
• Large price moves should be due to important news that change significantly the fundamental
value of the asset. Crashes must be exogenous.
• Markets are fundamentally efficient. Small mispricings are rapidly corrected by "those who know
the fundamental price" (whoever that is).
“Professor Fama is the father of modern efficient-markets theory, which says financial prices
efficiently incorporate all available information and are in that sense perfect. In contrast, I have
argued that the theory makes little sense, except in fairly trivial ways. Of course, prices reflect
available information. But they are far from perfect. [...] I emphasise the enormous role played
in markets by human error.”
– Robert Shiller 9
7
The fundamental value or intrinsic value is, according to Wikipedia, the "true, inherent, and essential value" of a financial
asset. Other definitions vary with the asset class, but clearly, it is a very ill-defined concept.
8
Clearly, also a very ill-defined concept.
9
Fama and Shiller shared the 2013 Nobel prize in Economics...
5.2.2 Empirical data and "puzzles"

A liquid stock counts 105 to 106 trades a day (over 1000 trades a minute). Clearly, news feeds fre-
quency is much lower. So, if prices really reflect value and are unpredictable, why do people trade so
much? This has been coined the excess trading puzzle. In the same vein, the price moves frequency is
too high to be explained by fluctuations of fundamentals (news arrival rate is much lower). This is the
excess volatility puzzle.
The latter puzzle suggests that a significant fraction of the volatility is of endogenous nature, in
contradiction with Fama’s theory. To a physicist, nontrivial endogenous dynamics is a natural feature
of a complex system made of a large number of interacting agents, very much like a bird flock or a
fish school. Imitation and feedback loops induce instabilities and intricate behavior consistent with the
statistical anomalies described above.
Empirical data actually suggests that over 90% of the volatility is of endogenous nature. Indeed,
restricting to large price jumps (> 4σ) and using a large news database, Joulin et al. [51] showed
that only 5 to 10% of 4σ-jumps can be explained by news. One may rightfully argue that however
large, there is no database which contains "all the news". Interestingly enough, one can show that
exogenous jump are less persistent than endogenous jumps, and thus cross-validate the jumps identified
as endogenous/exogenous. In particular, the volatility decay after a jump follows (see Omori law):
σ t>t jump − σ0 ∼ (t − t jump )−a , (5.10)
with a = 1 for an exogenous jump and a = 1/2 for an endogenous jump. To note, slow relaxation is a
characteristic feature of complex systems.
5.2.3 Continuous double auction

The vast majority of modern markets use a continuous-time double auction (CDA) mechanism im-
plemented through an electronic limit order book (LOB) updated in real time and observable by all
traders.10 In this setup each market participant may (i) provide firm trading opportunities to the rest
of the market by posting a limit order at a given price (liquidity provision),11 or (ii) accept such trading
opportunities by placing a market order (liquidity taking). The LOB stores, for a given asset on a given
platform, the limit orders until they are executed against incoming market orders or cancelled. The
price b t (resp. a t ) at time t of the highest buy (resp. lowest sell) limit order is coined the best bid (resp.
best ask). Buy (resp. sell) market orders are executed upon arrival against limit orders at the best ask
(resp. best bid). If the volume of an incoming market order is larger than that available at the best,
some of it will get executed against the best quote, and the rest of it against the next best quote in line,
see Fig. 5.5.
Figure 5.5: Limit order book (LOB).
10
Fama’s arguments disregard the way in which markets operate and how the trading is organised.
11
High frequency liquidity providers acting near the trade price are called market makers.
5.2. WHY DO PRICES CHANGE? 33
We define the midprice p t := (a t + b t )/2 and the bid-ask spread s t := a t − b t .12 The price axis is
discrete and the step-size is coined the tick size, typically 0.01$ for US stocks. When the average spread
is of the order of (resp. larger than) the tick size, one speaks of a large tick (resp. small tick) asset.
5.2.4 Liquidity and market impact

From the very nature of the trading mechanism, one can easily deduce that trades mechanically impact
prices. The market liquidity can be defined as the capacity of the market to accommodate a large market
order. Large trades consume liquidity and may "eat up" several queues in the order book. If there is
substantial volume in the best queues, the mid-price won’t be too affected. If on the other hand the
LOB stores very little volume (sparse LOB), the mid-price will be very sensitive to trades. Liquidity is
difficult to define because it is a dynamical concept, limit orders are continuously deposited, cancelled
and executed against incoming market orders.
Be that as it may, trades consume liquidity and impact prices, this is called market impact, or price
impact, or simply impact, commonly denoted I. It corresponds to the average price move induced by a
trade of sign ε (ε = +1 for buy trades, and −1 for sell trades):
I := 〈ε t · (p t+1 − p t )〉 . (5.11)
Note that I > 0 since, on average, buy trades push prices up while sell trades drag prices down.
From the perspective of the EMH, market impact is a substantial paradigm shift, prices appear to
move mostly because of trades themselves, very little because of new public information. One speaks of
price formation, rather than price discovery. Actually, because of the small outstanding liquidity, private
information (if any) can only be very slowly incorporated in prices.
Of interest for academics and practitioners, market impact is indeed both of fundamental and prac-
tical relevance. Indeed, in addition to being at the very heart of the price formation process, it is also the
source of substantial trading costs due to price slippage13 – also called execution shortfall.14 Significant
progress has been made in understanding market impact during the past decades [53–56].
5.2.5 Short-term mean reversion, trend and value

“Nowadays people know the price of everything and the value of nothing.”
– Oscar Wilde
Bachelier’s first law holds for timescales typically spanning from a few minutes to a few days. Below
and above several market "anomalies" arise. At very short timescales, prices tend to mean revert.15 At
longer timescales (few weeks to few months) prices returns tend to be positively autocorrelated (trend),
and at even longer timescales (few years) mean-revert. Actually, on such timescales the log-price π is
well described by an Ornstein-Uhlenbeck process driven by a positively correlated (trending) noise:
dπ 0
= −κπ t + η t , with 〈η t η t 0 〉 ∼ e−γ|t−t | , (5.12)
dt
where γ−1 ≈ few months and κ−1 ≈ few years. The intuitive explanation of this phenomenon is that
when trend signals become very strong it is very likely that the price is far away from the fundamental
value. Fundamentalists (investors believing in value) then become more active, causing price mean-
reversion, overriding the influence of chartists or trend-followers.
12
The spread represents the cost of an immediate round trip: buy then sell a small quantity results in a cost per share of s t ;
it also turns out to set the order of magnitude of the volatility per trade, that is the scale of price changes per transaction [52].
13
The slippage is the difference between the expected price of a trade and the price at which the trade is actually executed.
14
Slippage is usually of the order a few basis points (1 bp = 10−4 ).
15
For market makers mean-reversion is favourable while trending is detrimental (adverse selection).
Trends are one of the most statistically significant and universal anomalies in financial markets.
3.3.3 Results 3.3.3 Results Canadian stock index, we observe hints of bimodality (se
One can actually show that the overall performance of say, the 5-month trend, isobservation
somewhat intriguing
in fact positive over
since it suggests that the
every decadeInsince
this section we present
200 years In this
[57]. the
Trends results
section are ofclearly
we our estimation
present the results
hard toisprocedure
reconcile
beingobtain
introduced
of our estimation
with EMH,
over-priced orrobust
in Sec-
procedure
as it introduced
would mean in Sec-
under-priced. This was also recently
tion 3.3.2, applied to tion the 3.3.2,
time seriesapplied described
to the time in 3.3.1. seriesTo described ainmore 3.3.1. To obtain a more robust
that some (obvious) public information is not included in the Westerhoﬀ current price! Inline with Shiller’s ideas,
estimation procedure estimation
we will calibrate procedure parameters in two steps. In(2017). the first step we
16 we will calibrate parameters in two steps. In the first step we
trend and value seem inherent
calibrate each time series to human nature.
of log-prices
calibrate each time to obtain
series of asset specific
log-prices We statistically
tovalues
obtain ofasset confirm
N , gspecific
the of
and thevalues bimodality of mispricing
9 N , g and the
initial fundamental value initial v0 .fundamental
In the second value stepv0 .weInsearchSilverman
the secondfor a set (1981) test.
stepparameters
we search ,Thefor a set parameters the
null hypothesis of , test is th
, common
“The generally
V to
accepted an asset
Canadian view class
, Vindex,
stock iscommon
that (i.e. one set
to hints
markets
we observe an asset of
are
of parameters
class (see
always
bimodality bution
(i.e. for has
stock
[...].
one 12).
right.
Figure at
set This most
indices,
of Iparameters
tend
is a k modes,
one for where
to believestock k is a parameter
indices, one for
markets of the
commodities, one for
somewhat FX rates
intriguing
commodities,
are always wrong.” is being over-priced and
observationonesincefor
it government
suggests that the null hypothesis
bonds)
market’s mostthat
likely that
maximizes
state
one for FX rates and one for government bonds) that maximizes the distribution
the of mispricing for US equi
or under-priced. This was also recently reported in Schmitt and
common log-likelihood. common
Westerhoﬀ (2017). log-likelihood. mode (p-value is 1.5%) while the null hypothesis of the dis
– George Soros
In Table 3 (see We Appendix In Table
statistically A)
confirm we
3 report
the(see the
Appendix
bimodality resultsA)
of mispricing two
wefrommodesthe
report
distribution byEM cannot
the results
applying be
estimation rejected
from ofthe (p-value
EM is
estimation of
60.4%). We rece
Silverman (1981) test.9 The null hypothesis of the test is that the investigated distri-
model (3.7) with T-statistics
bution hasmodel of
at most k(3.7) estimated
modes, with k is aparameters
where T-statistics
parameter of in Table
distribution
estimated
of the test. 4parameters
The test (seeof Appendix
rejects mispricing
the A).
in Tableof Canadian
4 (see Appendixstock indexA). - p-valu
AssumingFrom
the this
existence weof
tablenull aFrom
observefundamental
hypothesis that
thatthis for
table allwe
distribution value,
assets
of observe
mispricing oneisthat
N for UScan for
equityeven
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pothesis
index show
assets
haslarger
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than
is
N mostone not only
This is
V . mode
substantially
one thep-value
larger
and market
than . This 90.6% for n
Vequals
mode (p-value is 1.5%) while the null hypothesis of the distribution having at most
confirms that
price quite dispersed aboutnoise
thetraders
fundamental
two modesconfirms
provide an important
value,
that noise
cannot be rejected
but that
(p-value traders
contribution
is 60.4%). provide
the
We receivetwohistogram
an to the
important
modes.
similar
ofvolatility
for thecontribution
resultsConsequently,
and
price-value distortions
at to
5% the volatility
significance is and
level we reject
that it is crucial
actually bi-modal, indicating tothat
include
distributionthat
assets itthem
isare
of mispricing ofin
crucial thetooften
most
Canadian HABM.
include This
them
either
stock index feature
inequals
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HABM.forbe oralso
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under-valued
hy- onbeFigure
also viewed
periods 12 have as one mode
pothesis of at most one mode and p-value equals 90.6% for null hypothesis of at most
another
of time [58, 59] (seepiece
Fig. of evidence
5.6). another for thepiecefamous
of evidence‘excessforvolatility
two modes. Consequently, at 5% significance level we reject
thehypothesis
famouspuzzle’‘excess
the hypothesis that
first
that both
reported
volatility
they by
havepuzzle’
at most first
tworeported
modes,by which sugge
Shiller (1980). empirical Shiller
distribution (1980).
plotted on Figure 12 have one modeofand mispricing
we cannot reject of US
the and Canadian index are bimodal.
hypothesis that they have at most two modes, which suggests that the distributions
of mispricing of US and Canadian index are bimodal.
price/value distortion pdf Canadian stock
-0.8 -0.4 0.0 0.4
Figure 12: Histogram of the price distortion for US stock index (left) and Canadian stock index
(right), using the non-linear model (4.1).
Note that the stochastic dynamic systems described by (3.3) or (4.1) indeed price/valu
undergo a phenomenological bifurcation (P-bifurcation) USinstock indexspace, which
parameter
Figure 12: Histogram of the price distortion for US stock index (le
means a qualitative change in the stationary distribution of mispricing from uni-
(right),
modal to bimodal. Since the Fokker-Planck equation associated using
with those the non-linear model (4.1).
systems
does not have a known solution, one has to use approximation methods to find the set
of parameters for which the bifurcation occurs. The result of the analysis of Chiarella
Figure 5.6: Price/value distortions on a US stock index for over two centuries, from [58]. Note
et al. (2008) and Chiarella et al. (2011) is the following condition that the stochastic dynamic systems described
for P-bifurcation:
Figure 3: Log-levelWe of Figure
the
apply the US
9 3: silvermantest,
stock
R package index, together
Log-level ofwhich anwith
theis US theundergo
stock smoothed
index,
implementation a fundamental
together
of Silverman test thevalue
(1981)with
phenomenological as bifurcation
smoothed fundamental (P-bifurcation)
value as in
taking into account modification suggested by Hall and York (2001) in order to prevent it from being
obtained from model (3.3) with
obtained parameters
from modelin Table
(3.3) 3.
withWe also
parametersplot value plus/minus standard one
too conservative. means a qualitative change plus/minus
in Table 3. We also plot value standard one
in the stationary distribution
deviation of the estimation interval,ofandthethe benchmark fundamental the value
deviation estimation interval, and modal to obtained
benchmark
bimodal. from Gordon
fundamental
Since value obtained from Gordon
the Fokker-Planck equation assoc
model. shifting
5.2.6 Paradigm model. 26
does not have a known solution, one has to use approximatio
of parameters for which the bifurcation occurs. The result o
Two different scenarios for price changes have been exposed: fundamental value driven prices, and
In prices.
Figure 3 we present the smoothed estimate etfundamental
al. (2008) and Chiarella aet al. (2011) is the following co
order flow driven In Figure 3 we present theofsmoothed estimate value of(using
fundamental value (using a
Kalman smoother) forKalman
the US stock indexfor
smoother) given
the the
US estimatedWe parameters
stock 9index given
apply thethe in Tablesilvermantest,
R estimated
package 3.parameters inwhich
Tableis 3.
an implement
taking into account modification suggested by Hall and York (2001) in
1. Within the EMH or price discovery framework, prices are exogenous. Prices reflect fundamental
15 too conservative.
15
values, up to small and short-lived mispricings (quick and efficient digestion). Market impact is
non other than information revelation, the order flow adjusts to changes in fundamental value,
26
regardless of how the trading is organised.
While consistent with martingale prices and fundamentally efficient markets (by definition new
information cannot be anticipated), this view of markets comes with some major puzzles. In ad-
dition to the whole idea of markets almost immediately digesting the information content of news
being rather hard to believe, one counts in particular the excess trading, the excess volatility and
the trend-following puzzles. The concept of high frequency non-rational agents, noise traders, was
artificially introduced in the 80’s to cope with excess trading and excess volatility. But however
noisy, noise traders cannot account for excess long-term volatility and trend-following.
2. Within the order-driven prices or price formation framework, prices are endogneous, mostly af-
fected by the process of trading itself. The main driver of price changes is the order flow, re-
gardless of its information content. Impact is a mechanical statistical effect, very much like the
response of a physical system.
16
Artificial market experiments show that even when the fundamental value is known to all, one is tempted to forecast the
behaviour of their fellow traders which ends up creating trends, bubbles and crashes. The temptation to outsmart one’s peers
is too strong to resist.
5.3. AGENT-BASED MODELS FOR PRICE CHANGES 35
Here, prices are thus perfectly allowed to err away from the fundamentals (if any). Further,
excess volatility is a direct consequence of excess trading! This scenario is also consistent with
self-exciting feedback effects, expected to produce clustered volatility: the activity of the market
itself leads to more trading which, in turn, impacts prices and generates more volatility and so
on and so forth.
While probably more convincing – and more inline with real data – than the EMH view, one
caveats remain at this stage: the market efficiency. Indeed, let’s recall that despite the anomalies
discussed above, for reasonable timescales prices are approximately martingales. How can the
order-driven prices perspective explain why signature plots are so universally flat? Fundamental
efficiency is replaced with statistical efficiency, the idea being that efficiency results from compe-
tition: traders seek to exploit statistical arbitrage opportunities, which, as a result, mechanically
disappear,17 by that flattening the signature plot.
Finally, note that the very meaning of what a good trading strategy is varies with one’s view. Within
the EMH, a good strategy is one which predicts well moves in the fundamental value. With mechanical
impact, a good strategy aims at anticipating the actions of fellow traders, the order flow, rather than
fundamentals.
5.3 Agent-based models for price changes

Here we present two insightful agent-based models to account for fat-tailed returns and self-organised
criticality. Note that many of the models presented in the previous Chapters apply to financial markets,
with in particular the RFIM, Marsil and Curty’s forecasting game, Kirman’s ant model, and the Langevin
dynamics model presented in Chapter 3.
5.3.1 Herding and percolation

Here we present a simple model to understand how mimicry and herding can affect price fluctuations
[60]. The ingredients of this model are:
• Consider a large number N of agents.

• Assume that returns r are proportional to demand-supply imbalance as:
N
1X φ
r= ϕi := , (5.13)
λ i=1 λ
where ϕi ∈ {−1, 0, 1} signifies agent i selling, being inactive, or buying, and λ is a measure of
market depth.
• Agents i and j are connected (or interact) with probability p/N (and ignore each
P other with
probability 1 − p/N ), such that the average number of connections per agent is j6=i p/N ≈ p.
• If two agents i and j are connected, they agree on their strategy: ϕi = ϕ j .
Percolation theory teaches us that the population clusters into connected groups sharing the same
opinion, see e.g. [61]. Denoting by nα the size of cluster α, one has:
1X
r= nα ϕ α , (5.14)
λ α
where ϕα is the common strategy within cluster α. Price statistics thus conveniently reduce to the
statistics of cluster sizes for which many results are known. In particular, on can distinguish three
regimes.
17
See e.g. the Minority Game presented hereafter.
1. As long as p < 1 all cluster are small compared to the total number of agents N , and the proba-
bility distribution of cluster sizes scales as:
1
P(n) ∼ exp(−ε2 n) , (5.15)
n5/2
with ε = 1 − p 1. The market is unbiased 〈r〉 = 0 (as long as ϕ = ±1 play identical roles).
2. When p = 1, equivalently ε = 0 (percolation threshold), P(n) becomes a pure power-law with

exponent µ = 3/2, and the generalised CLT implies that the distribution of returns converges to
a pure symmetric Levy distribution of index µ = 3/2.
3. If p > 1, there exists a percolation cluster of size O(N ), or in other words there exists a finite frac-
tion of agents with the same strategy, 〈φ〉 6= 0 ⇒ 〈r〉 6= 0, and the market crashes. A spontaneous
symmetry-breaking occurs.
This quite instructive model gives the "good" distribution of returns (µ = 3/2 is observed for the
MXN/$ rate) and the possibility for crashes when the connectivity of the interaction network increases.
However, this story holds only if the system sits below, but very close to the instability threshold. But
what ensures such self-organised criticality where the value of p would stabilise near p ® 1? In section
5.3.2, we give a stylised example illustrating why such systems could be naturally attracted to the
critical point. Further, note that this model is static and thus not relevant to account for volatility
dynamics. How do these clusters evolve with time? How to model opinion dynamics? An interesting
extension of this model was proposed in [62]: by allowing each agent to probe the opinion of a subset
of other agents and either conform to the dominant opinion or not if the majority is too strong, one
obtains a richer variety of market behaviors, from periodic to chaotic.
5.3.2 The minority game

Some of the models presented above are only relevant and interesting if the system sits very close to the
instability threshold. But what ensures such self-organised criticality where the order parameter would
stabilise near its critical value? Here, we give a stylised example illustrating why complex systems made
of heterogeneous and interacting agents can often be drawn to criticality: the Minority Game [63]. It
is inspired from the theory of spin-glasses and disordered systems in statistical physics.
The ingredients of the model (in its simplest setting) are as follows:
• Consider a large number N of agents who must make a binary choice, say ±1.
• At each time step, a given agent wins if and only if he chooses the option that the minority of his
fellow players also choose. By definition, the number of winners is thus always < N /2.
• At the beginning of the game, each agent is given a set of strategies fixed in time (he cannot try
new ones or slightly modify the ones he has in order to perform better). A strategy takes as input
the string of, say M past outcomes of the game, and maps it into a decision. The total number of
M
possible strategies is 22 (the number of strings is 2 M and to each of them can be associated +1
or −1). Each agent’s set of strategies is randomly drawn from the latter. While some strategies
may be by chance shared, for moderately large M , the chance of repetition is exceedingly small.
• Agents make their decision based on past history. Each agent tries to rank his strategies according
to their past performance, e.g. by giving them scores, say +1 every time a strategy gives the
correct result, −1 otherwise. A crucial point here is that he assigns these scores to all his strategies
depending on the outcome of the game, as if these strategies had been effectively played, by that
neglecting the fact that the outcome of the game is in fact affected by the strategy that the agent is
actually playing.18
18
Note that this is tantamount to neglecting impact and crowding effects when backtesting an investment strategy.
5.4. DIMENSIONAL ANALYSIS IN FINANCE 37
The game displays very interesting dynamics which fall beyond the scope of this course, see [63–65].
Here, we focus on the most striking and generic result. We introduce the degree of predictability H
(inspired from the Edwards-Anderson order parameter in spin-glasses) as:
2M
1 X
H= M 〈w|h〉2 , (5.16)
2 h=1
where 〈w|h〉 denotes the average winning choice conditioned to a given history (M -string) h. One can
show that the number of strategies does not really affect the results of the model, and that in the limit
N , M 1 the only relevant parameter is α = 2 M /N . Further, one finds that there exists a critical point
αc (≈ 0.34 when the number of strategies is equal to 2) such that for α < αc the game is unpredictable
(H = 0) whereas for α > αc the game becomes predictable in the sense that conditioned to a given
history h, the wining choice w is statistically biased towards +1 or −1 (H > 0). In the vocabulary of
financial markets, the unpredictable and predictable phases can be called the efficient and inefficient
phases respectively.
At this point, it is easy to see that, by allowing the number of players to vary, the system self-
organises such as to lie in the immediate vicinity of the critical point αc . Indeed, for α > αc , corre-
sponding to a relatively small number of agents N , the game is to some extent predictable and thus
exploitable. This is an incentive for new agents to join the game, that is N ↑ or equivalently α ↓. On
the other hand, for α < αc , corresponding to a large number of agents N , the game is unpredictable
and thus uninteresting to extract profits. Agents leave the game, that is N ↓ or equivalently α ↑. This
mechanism spontaneously tunes α → αc .
By adapting the rules the Minority Game can be brought closer to real financial markets, see [65].
The critical nature of the problem around α = αc leads to interesting properties, such as fat tails and
clustered volatility. Most importantly, the conclusion of an attractive critical point (or self-organised
criticality) is extremely insightful: it suggests that markets operate close to criticality, where they can
only be marginally efficient!
5.4 Dimensional analysis in finance

Benoit Mandelbrot was the first to propose the idea of scaling in the context of financial markets [66], a
concept that blossomed in statistical physics well before getting acceptance in economics, for a review
see [67]. In the last thirty years, many interesting scaling laws have been reported, concerning different
aspects of price and volatility dynamics. In particular, the relation between volatility and trading activity
has been the focus of many studies, see e.g. [68–74] and more recently [52, 75, 76].
5.4.1 Vaschy-Bukingham π-theorem

Dimensional analysis states that any law relating different observables must express one particular
dimensionless (or unit-less) combination of these observables as a function of one or several other such
dimensionless combinations. More precisely, the Vaschy-Bukingham π-theorem states that if a physical
equation involves n physical variables and m non-linearly dependent fundamental units, then there
exists an equivalent equation involving n − m dimensionless variables constructed from the original
variables.
5.4.2 An example in physics: The ideal gas law

The simplest illustrative example might be the ideal gas law, that amounts to realising that pressure P
times volume V has the dimension of an energy. Hence PV must be divided by the thermal energy RT
of a mole of gas to yield a dimensionless combination. The right-hand side of the equation must be a
function of other dimensionless variables, but in the case of non-interacting point-like particles, there
is none – hence the only possibility is PV /RT = cst.
Deviations from the ideal gas law are only possible because of the finite radius of the molecules,
or the strength of their interaction energy, that allows one to create other dimensionless combinations,
and correspondingly new interesting phenomena such as the liquid-gas transition.
5.4.3 An example in finance: The ideal market law

Kyle and Obizhaeva recently proposed a bold but inspiring hypothesis, coined the trading invariance
principle [77]. In the search of an ideal market law, several possible observables that characterise
trading come to mind:
• the share price p in $ per share,

• the square volatility of returns σ2 in %2 per unit time,
• the volume of individual orders Q in shares,
• the trading volume V in shares per unit time,
• and the trading cost C in $.19
Let us assume there exists an equation relating these n = 5 variables of the form:
f (p, σ2 , Q, V, C) = 0 . (5.17)
The number of non-linearly dependent units m can be computed as the rank of the following matrix:
$ shares T
p 1 −1 0
 
σ2 0 0 −1
Q 0 1 0
 
V 0 1 −1
 
C 1 0 0
Here m = 3 such that according to the Vaschy-Bukingham π-theorem there exists an equation equiva-
lent to Eq. (5.17) involving n − m = 2 dimensionless variables. One can for example choose:
Qσ2

pQ
= g , (5.18)
C V
with g a dimensionless function that cannot be determined on the basis of dimensional analysis only.
Invoking the Modigliani-Miller theorem which argues that capital restructuring between debt and
equity should keep p × σ constant, while not affecting the other variables. This suggests that g(x) ∼
x −1/2 , finally leading to the so-called 3/2 law:
W ∼ C N 3/2 , (5.19)
where we introduced the trading activity or exchanged risk W := pV σ and the trading rate N = V /Q.
5.4.4 Empirical evidence

Several empirical studies (see e.g. [77–80]) have shown that the 3/2 law holds remarkably well on
average at the single-trade scale and metaorder scale on different asset classes, see Fig. 5.7.
Days of anomalously high volatility display deviations from the trading invariance principle, which
could be exploited by regulators as yet another indicator for market anomalies. Similar to the devia-
tions away from the ideal gas law in the example discussed above, deviations from trading invariance
may suggest that additional microstructural variables must be involved in the search of a relation gen-
eralising the ideal market law to all market conditions. In some regimes, the bid-ask spread and the
19
Other more microstructural quantities might come into play, such as the spread (in $ per share), the tick size (in $) that
sets the smallest possible price change, the lot size (in shares) that sets the smallest amount of exchanged shares, the average
volume available at the best quotes, and perhaps other quantities as well.
5.4. DIMENSIONAL ANALYSIS IN FINANCE 39
Figure 5.7: Trading activity against trading frequency for (a) 12 futures contracts and (b) 12 US stocks,
from [79]. The insets show the slopes α obtained from linear regression of the data, all clustered around
3/2.
tick size, among other things, could play an important role – like the molecular size in the ideal gas
analogy. Besides, note that while the Modigliani-Miller theorem is intended for stocks, the 3/2 law
unexpectedly does hold also for futures (see Fig. 5.7) for which the Modigliani-Miller argument does
not have any theoretical grounds.
Dimensional analysis is a powerful tool that has proved its worth in physics, but that is yet under-
exploited in finance and economics. The prediction that exchanged risk W, also coined trading activity,
namely W = price × volume × volatility, scales like the 3/2 power of trading frequency N , is well sup-
ported by empirical data, both at the trade-by-trade and metaorder levels. The dimensionless quantity
W /(C N 3/2 ), where C denotes the trading costs, is a good candidate for a trading invariant across as-
sets and time. Finally, let us stress that unveiling the mysteries of the enigmatic 3/2 law from the
microscopic 3/2 law is yet to be done: is the 3/2 an approximate happy coincidence, or is there a deep
principle behind it?
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Physic of Socioeconomic System (Cours Polytechnique)

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OMI 446: Physics of Socioeconomic

ENSAE IP Paris – 1st year

February 14, 2020

1 Choice theory and decision rules 3

2 Imitation of the peers and other interactions 7

3 Imitation of the past 17

The content of this course is mainly inspired by references [1, 2].

Choice theory and decision rules

1.1 The logit rule

1.1.1 What is it?

eβu1 eβ∆u 1 β∆u

1.1.2 How should I interpret it?

1.2 Master equation

1.3 Detailed balance

pγ (t)R> (uγ − uα ) = pα (t)R> (uα − uγ ) , (1.4)

log R> (−∆u)

Imitation of the peers and other

2.1 Collective behaviour

2.1.2 Power laws, scale invariance and universality

2.2 Mimicry and opinion changes

2.2.1 The random field Ising model

• The incentive ∆ui of agent i to choose +1 over −1 is given by:2

encoding that the decision of agent i depends on three distinct factors:

choosing +1, one can easily show that:

2.2.2 Collective decision making with heterogeneities

• If the number of agents Nt+ exceeds N (1 − ci ), then agent i joins at t + 1.

In the continuous limit (large N ) this is

Figure 2.3: Fixed points of the 1st Shelling model.

2.2.3 The limits of copy-cat strategies

• Consider a large number N of agents who must make a binary choice.

Figure 2.4: Fixed points of the Marsili & Curty game.

2.2.4 Kirman’s ants, herding and switching

2.3 Segregation, Schelling and the invisible hand

Imitation of the past

3.1 Memory effects

3.1.1 Estimation error and learning

ûα (t) = uα + εα (t) , where now εα (t) = εα (0)e−Γα t . (3.1)

3.1.2 Habit formation

Figure 3.1: Illustration of habit formation in an exploration-exploitation setup.

3.2 Self-fulfilling prophecies

• A context of repeated decisions (such as investing in financial markets).

“ A conventional valuation which is established as the outcome of the mass psychology of

3.3 Feedback and instabilities

3.3.1 Langevin dynamics

φ t+1 − φ t = ar t − br t2 − a0 r t − k(p t − pF ) + χξ t . (3.4)

3.3.2 Excess volatility, bubbles and crashes

increases linearly on average 〈p t − pF 〉 ∼ u† t with no economic justification whatsoever. This

4.1 Why fish markets?

4.2 The Marseille fish market

4.3 Trading relationships and loyalty formation

• N buyers i ∈ [1, N ] and M sellers j ∈ [1, M ].

Ji j (t) = πi j (t) + (1 − γ)Ji j (t − 1) , (4.1)

4.3.2 Mean Field Analysis

∂ t Ji j = −γJi j + 〈πi j 〉 . (4.3)

〈πi j 〉 = P(q j > 0)pi j π̄ , (4.4)

with π̄ the average profit obtained from getting a quantity q j .1

4.3.3 Beyond Mean Field

4.3.4 Heterogeneities and real data

4.4 The impact of market organisation

eβu1 eβ∆u 1 β∆u