Using multi-agent simulation to understand trading dynamics of a derivatives market

A fundamental question that arises in derivative pricing is why investors trade in a particular derivative at a "fair" price supplied by Arbitrage Pricing Theory (APT). APT establishes a price that is fair for a disinterested investor with a particular set of beliefs about market evolution and attributes trading to differences in those beliefs entertained by the opposite sides of the transaction. We present a model for an investor in a frictionless market that combines investors' incentives in the form of pre-existing liability structures with derivatives pricing procedure tailored for a particular investor. This model enables us to show, through a series of experiments, that investors trade even when their belief structures are identical and accurate. More generally, our study suggests that multi-agent simulation of a financial market can provide a mechanism for conducting experiments that shed light on fundamental properties of the market. As all processes in financial markets (including decision making) become automated, it becomes crucial to have a mechanism by which we can observe the patterns that emerge from a variety of possible investor behaviors. Our simulator, designed as a dealer's market, provides such a mechanism within a certain range of models. © Springer 2005.