Tuesday, May 14, 2019

The Model Thinker #19 : Threshold Models with Feedbacks

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Sometimes it helps to go granular and model something as an agent instead of system dynamics models. So this means that instead of modelling a stock-market as having a number of value versus growth investors, we can model each investor as someone who will buy or sell a stock based on some threshold.

The problem with modelling each investor as an agent is that we run into other problems.

Some investors will buy a stock when it goes up, making the stock go up even higher. This is an example whereby an agent produces positive feedback loops. Other investors will do the opposite and buy the stock when it goes down. This is an example whereby an agent produces negative feedback loops.

A system with primarily positive feedback would be like cryptocurrency markets when prices of bitcoin blew up or collapsed. If you really believe that the cryptocurrency markets will moon over the next few months while the trade war is going on, you might be making a bet that cryptocurrency agents are mostly trend followers and the current trend is up all thanks to the trade war. My theory is that some folks believe that China can go nuclear by selling US treasury bonds. This will push up the price of Bitcoins.

My opinion is that the REITs markets are possibly the opposite of cryptocurrency markets. A lot of REIT investors chase dividend yields and this is primary a market with a lot of negative feedback. When REIT prices drop, yields go up and this attracts yield hunters. REIT markets, therefore, will either stabilise or move in very shallow cycles. This is why I observe empirically that REIT portfolios I build with my students have such a low effective shortfall the expected loss in 1 out of 100 months is less than 6%.

The insight that cryptocurrency markets and REITs markets are opposite poles when it comes to feedback is an interesting one which I am now cracking my head at.

Can a strategy be developed to exploit this ?

I already have a paper on factor based models for cryptocurrency markets and when markets are down, crypto seems to making an interesting recovery.

Perhaps a hedging strategy for REITs can be built with Bitcoins ?

Let me know what you think.

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