The excess volatility puzzle explained by financial noise amplification from endogenous feedbacks.

Area of Science:

• Financial economics
• Complex systems analysis
• Quantitative finance

Background:

• The excess volatility puzzle, identified by Robert Shiller in 1981, highlights that asset prices fluctuate significantly more than their fundamental values.
• This phenomenon suggests inherent instabilities within financial markets.
• Such market dynamics are observed in foreign exchange and equity futures markets.

Purpose of the Study:

• To explain the excess volatility puzzle in financial economics.
• To decompose price fluctuation volatility into exogenous and endogenous components.
• To investigate the role of endogenous feedback in market instabilities.

Main Methods:

• Utilized an exact mapping of price diffusion process volatility to a point process.
• Employed a self-excited epidemic model to analyze price changes.
• Decomposed volatility into exogenous (efficient) and endogenous (inefficient) components.

Main Results:

• Identified a substantial endogenous component contributing to excess volatility.
• Found this endogenous component to be stable over longer time scales.
• Demonstrated that micro-scale fluctuations are amplified into long-term excess volatility.

Conclusions:

• The endogenous excess volatility provides a plausible explanation for the excess volatility puzzle.
• The findings are applicable to complex systems with exogenous driving and endogenous feedback.
• The study rationalizes the amplification of small market fluctuations into significant long-term price volatility.