Analytical study of index-coupled herd behavior in financial markets

School of Physics and Astronomy, Tel-Aviv University - Tel-Aviv, Israel

Received: 30 August 2016
Accepted: 11 January 2017

Abstract

Herd behavior in financial markets had been investigated extensively in the past few decades. Scholars have argued that the behavioral tendency of traders and investors to follow the market trend, notably reflected in indices both on short and long time scales, is substantially affecting the overall market behavior. Research has also been devoted to revealing these behaviors and characterizing the market herd behavior. In this paper we present a simple herd behavior model for the dynamics of financial variables by introducing a simple coupling mechanism of stock returns to the index return, deriving analytic expressions for statistical properties of the returns. We found that several important phenomena in the stock market, namely the correlations between stock market returns and the exponential decay of short-term autocorrelations, are derived from our model. These phenomena have been given various explanations and theories, with herd market behavior being one of the leading. We conclude that the coupling mechanism, which essentially encapsulates the herd behavior, indeed creates correlation and autocorrelation. We also show that this introduces a time scale to the system, which is the characteristic time lag between a change in the index and its effect on the return of a stock.