Market Instability, Investor Sentiment and the Probability Weighting Functions Implied by Risk Sources of Index Option Prices

Seminar abstract

How do financial markets switch from states of optimism to pessimism and vice versa?

How does a seemingly stable financial market become unstable and crash?

What is the probability that a seemingly stable financial markets will be come unstable over time?

Are there quantifiable early warning signals that the market is at a tipping point?

We answer those questions in the context of a natural experiment with risk based sources of Probability Weighting Functions (PWFs), i.e. source functions, implied by S and P 500 index option prices. Source functions reflect (re)ranking assets attractiveness and the wright investors place on each rank. 

We introduce a novel behavioural process (hereinafter BELLE), constructed from time dependant noise in financial decision making in the presence of risk.

The BELLE process characterises the critical tipping points for investor sentiment, probabilistic risk attitudes about tail events, and early warning signals of market instability.

It also admits a closed form expression for the the probability that a seemingly stable market state will switch to an unstable state.

The BELLE process predicts;

1. state transitions in sentiment,
2. the degree of investors' optimism and pessimism in the market,
3. mania, panic and crash from the market's irrational exuberance or high uncertainty about asset quality.

The model is robust to different to different sources of risk. Thus, we address Minsky's second theorem:

An economy has financial relations that make for a stable state and financial relations that make for an unstable state.

Booking

This is a free event. Please bring along your colleagues, friends and classmates.

Speaker bio

Dr Godfrey Charles-Cadogan is a Lecturer in Finance at the University of Leicester. Joining the School of Business in 2016, having previously taught in Johannesburg. He gained his PhD from the University of Cape Town with an emphasis on Statistical Economics.

His research interests include;

• behavioural probability
• behavioural decision theory and stochastic processes
• financial economics
• econometrics theory

His current research includes construction of a credit risk index with myopic loss aversion to credit default as well as

• behavioural asset pricing  and rare disasters,
• econometric tests for hedge factors performance,
• managerial compensation contracts in revolving door setting,
• probabilistic risk attitudes and irrational exuberance in financial market instability

Godfrey's research has been presented at leading international peer reviewed conferences in econometric theory, financial economics, mathematical finance and decision theory.

His paper on risk torsion concept was voted by Money Science as one of the top innovative papers. His modified Sharpe ratio statistical for high frequency traders' performance evaluation was also recommended for practitioners. 

 His work has been published in a variety of peer reviewed journals including; 

• Journal of Mathematical Economics
• Journal of Economic Behaviour and Organisation
• Journal of Investment Strategies
• Financial Research Letters
• Handbook of High Frequency Trading
• System Research and Behavioural Science
• Proceeding of American Statistical Association
• Business and Economics Section