An evolutionary game theory explanation of ARCH effects

While ARCH/GARCH equations have been widely used to model financial market data, formal explanations for the sources of conditional volatility are scarce. This paper presents a model with the property that standard econometric tests detect ARCH/GARCH effects similar to those found in asset returns. We use evolutionary game theory to describe how agents endogenously switch among different forecasting strategies. The agents evaluate past forecast errors in the context of an optimizing model of asset pricing given heterogeneous agents. We show that the prospects for divergent expectations depend on the relative variances of fundamental and extraneous variables and on how aggressively agents are pursuing the optimal forecast. Divergent expectations are the driving force leading to the appearance of ARCH/GARCH in the data. (C) 2006 Elsevier B.V. All rights reserved.