Physica A 391 (2012) 55325545

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Physica A
journal homepage: www.elsevier.com/locate/physa
Formation of share market prices under heterogeneous beliefs and
common knowledge
Yuri Biondi
a
, Pierpaolo Giannoccolo
b
, Serge Galam
c,
a
Ple de Recherches en conomie et Gestion (PREG), cole Polytechnique and CNRS, Boulevard Victor, 32, F-75015 Paris, France
b
Department of Economics, University of Bologna, 40100 Bologna, Italy
c
Centre de Recherche en pistmologie Applique (CREA), cole Polytechnique and CNRS, Boulevard Victor, 32, F-75015 Paris, France
a r t i c l e i n f o
Article history:
Received 28 October 2011
Received in revised form 28 May 2012
Available online 21 June 2012
Keywords:
Opinion dynamics
Sociophysics
Econophysics
Reactiondiffusion
Bubble formation
Market dynamics
Market price formation
a b s t r a c t
Financial economic models often assume that investors know (or agree on) the
fundamental value of the shares of the firm, easing the passage from the individual to
the collective dimension of the financial system generated by the Share Exchange over
time. Our model relaxes that heroic assumption of one unique true value and deals with
the formation of share market prices through the dynamic formation of individual and
social opinions (or beliefs) based upon a fundamental signal of economic performance and
position of the firm, the forecast revision by heterogeneous individual investors, and their
social mood or sentiment about the ongoing state of the market pricing process. Market
clearing price formation is then featured by individual and group dynamics that make its
collective dimension irreducible to its individual level. This dynamic holistic approach can
be applied to better understand the market exuberance generated by the Share Exchange
over time.
2012 Elsevier B.V. All rights reserved.
1. Introduction
Advances in heterogeneous agents modeling from economics [1,2] and complex systems dynamics in sociophysics [3,4]
call for an understanding of the working of the financial market based upon the collective and dynamic properties of systems
featured by interacting parts and structures. These elements can be atoms or macromolecules in a physical context, as well
as investors, firms or regulated Exchanges in a socio-economic context. These approaches aimthen to analyze the properties
of socio-economic systems over time by focusing on interactions, relationships and the overall architecture of those systems
[5,6].
Drawing upon these advances, this paper integrates the phenomenon of opinion dynamics studied by sociophysics [7,8]
to an economic dynamic model of market price formation over time through hazard, ignorance and interaction [9]. The study
of opinion dynamics has been a long and intensive subject of research among physicists working in sociophysics [1016]:
we apply here the Galam sequential probabilistic majority model of opinion dynamics [1618].
During the last decades, financial market analysis has assisted in the proliferation of financial economic models that
relax received assumptions of full knowledge, individual rationality and market efficiency. However, many models remain
somewhat tied to an equilibrium approach to the formation of share market prices over time. This approach entails a
pricing rule that satisfies all the market orders simultaneously passed by all investors in the purpose of maximizing their
expected utilities. This approach actually implies a peculiar understanding of the market coordination between individual

Corresponding author.
E-mail addresses: yuri.biondi@polytechnique.edu (Y. Biondi), pierpaolo.giannoccolo@unibo.it (P. Giannoccolo), serge.galam@polytechnique.edu
(S. Galam).
0378-4371/$ see front matter 2012 Elsevier B.V. All rights reserved.
doi:10.1016/j.physa.2012.06.015
Y. Biondi et al. / Physica A 391 (2012) 55325545 5533
investors. This coordinationis supposedto be achievedina solitary moment beyondtime andcontext [19] whenall investors
contemplate the past, present and future of the business firm and univocally agree on its fundamental value of reference.
Once this unanimous consensus achieved, they perform market transactions at that price, which does not change unless
the fundamental value of the firm does change [20]. Therefore, the share market price is supposed to incorporate (all the
available information on) the fundamental value of the firm at every instant [21,22]. The share market price becomes a
sufficient statistics of the fundamental value of the firm [23], and investors are then supposed to know (or agree with) the
fundamental value of its shares, even though the current market price may diverge from this true value in some ways
over time. The understanding and the modeling of market pricing, and the dynamics of individual and collective opinions,
are then driven by this assumption of uniqueness of the value of the firm.
Our model relaxes this heroic assumption of the market price as the best evidence of the true value, and deals with
the formation of share market price of one firmthrough the dynamic formation of individual and social opinions (or beliefs)
based upon a fundamental signal F
t
on the economic performance and position of the firm, the market clearing price of
each share p
t
, and a social mood (or sentiment) m
t
on the ongoing state of market pricing process. Accordingly, individual
investors are assumed to formtheir personal opinions which orient their financial decisions to sell or hold, and buy or wait
in a fundamentally interactive context [24]. At every instant k, each investor i does form its opinions respectively on the
evolution of corporate fundamentals and the market clearing price that is continuously changed by achieved transactions
through the Share Exchange.
Nothing can assure one investor about the permanent alignment between his opinion on the evolving fundamentals,
its opinion on the current market price, and the market price itself [25]; nor can it be sure that the market order which
it passes through the Share Exchange according to those opinions may be eventually satisfied. In this dynamic setting,
the formation of share prices critically depends on both the interactive formation of social opinions among investors, and
their common knowledge of corporate fundamentals over time. Every investor strives then to revise its price expectations
E
t
(p
t+1
)|
i
according to the dynamics of the fundamental signal F
t
and the social market sentiment m
t
. In this way, we
develop a theoretical model of financial price formation over socio-economic space and time based upon the combination of
individual, group, andcollective levels of analysis. Bothindividual idiosyncratic investment strategies, the formationof social
opinions through investor group interaction, and collective coordination through the Share Exchange and the provision
of fundamental signals, play distinctive roles in our framework of analysis. Indeed we are in line with recent theoretical
advances aiming to formalize the co-evolution of market prices and corporate fundamentals through socio-economic
interaction in a consistent and parsimonious way, while capturing some stylized facts from empirical evidence [2634].
2. Definition of variables and timing
According to our model, the formation of share market price over time depends on the dynamic formation of individual
andsocial opinions (or beliefs) basedupona fundamental signal F
t
onthe economic performance andpositionof the firm, the
market clearing price of each share p
t
, and a social mood (or sentiment) m
j
t
about the market pricing. These three dimensions
(or layers, or orders) correspond to three different rhythms of change, that is, three different timings:
F
t,h
, the fundamental signal, has the slowest rhythm or the largest lag (duration). This means that F
t
can be constant for
t +h periods; it lasts for h periods;
p
t
, the market clearing price, when it exists, changes at each period t;
m
j
t,k
, the social mood, has the quickest rhythm or the shortest lag. At each period t, its value is the final result of k
interactions; each mood lasts indeed for
1
k
periods.
Two distinctive forces drive the market clearing price formation through time. From one side, ongoing market pricing
is submitted to individual guesses and intentions, hopes and fears, subsumed by the social mood m
j
t,k
and its quickest
interactions; fromanother side, it is concerned with the slowest history of reporting and disclosure that, in principle, may be
partly public, consistent, and conventionally agreed. This general system(which is no longer an equilibrium)
1
consists in and
depends upon the coherence and universal diffusion of relevant and reliable knowledge through a price system (providing
market information) and an accounting system(disclosing firm-specific, fundamental information) publicly determined and
announced.
In particular, the fundamental signal is assumed to be common knowledge among all investors:
F
t
is the fundamental signal about the economic performance and position generated by the business firm over time; it
is fundamentally related to the firms share price, but agents do not know (or agree on) the working of this relationship;
F
t
can be positive or negative and is exogenous to the model;
By assumption

F
t
0;
Each agent applies an individual weight
i
[0; 1] to this signal, related to its personal confidence degree on it, from

i
= 0 (no confidence at all) to
i
= 1 (full confidence); this implies that all agents agree on the direction (sign) of the
fundamental signal, but disagree on its material impact on the share price;
In some specifications of the model, F
t
may influence the social mood m
j
t,k
;
1
Our analysis distinguishes system and equilibrium as distinctive concepts.
5534 Y. Biondi et al. / Physica A 391 (2012) 55325545
The social mood (or market sentiment) captures the group interaction that generates the collective opinion on the current
state of market pricing:
m
j
t,k
[0; 1] is the mood of group j at time t, resulting from k group interactions (steps) starting from m
j
t,k=0
;
At each time t, m
j
t,k=0
[0; 1] exists and is exogenous to the model; in fact, m
j
t,k=0
may be endogenous to the model; in
particular, it may depend on F.
The market clearing price (when it exists) is generated by the matching of aggregate supply and demand, which are based
upon heterogeneous price expectations by individual agents:
p
t
is the market clearing price at time t;
By assumption, p
t
0;
E
t
(p
t+1
)|
j
i
is the price expectation at time t by agent i belonging to the group j on the market clearing price at period t +1.
Individual investors have both group and individual heterogeneities regarding the formation of their expectations, which
are then based upon individual and social opinions (or beliefs). In particular:
Investors are distinguished between actual and potential shareholders. Analytically, they belong then to two groups
j = S, D, where S denotes supply by potential sellers (actual shareholders), while D denotes demand by potential buyers
(potential shareholders);
In each group j, the number of agents is normalized to one, with i [0; 1];
In each group j, every agent i is characterized by an individual weight
i
[0; 1] that is applied to the fundamental
signal F
t
;
In each group j, agents are further characterized by the social mood m
j
t,k
that constitutes the market sentiment expressed
by group j at time t; its weight results from k inter-individual interactions between t 1 and t.
3. The formation of individual expectations
It has been advocated that the two broad categories of chartism and fundamentalism account for most of possible
investment strategies [35]. On this basis, every agent forms its price expectation according to the following generic
function [36,37]:
E
t
(p
t+1
)|
j
i
= p
t
+m
j
t,k
(p
t
p
t1
)
j
i
_
E
t1
(p
t
)|
j
i
p
t
_
+
j

i
F
t
(1)
with j = S (Supply), D (Demand); i,
i
[0, 1] ; m
j
t,k
[0, 1] ;
j
i
[0; 1] ;
j
> 0, and

j
i,t

_
E
t1
(p
t
)|
j
i
p
t
_
. (2)
This equation comprises four elements. The first element is the past clearing price p
t
. The second element is the market
signal (or price trend) that is weighted by the social opinion m
j
t,k
of the group j at time t, expressing the groups ongoing
market confidence. The third element is the individual forecast revision that consists of the difference between the past price
expectation and the current realized price. This revision is weighted by
j
i
which may include both group and individual
heterogeneities. The forth element denotes the formation of an individual opinion by investor i (belonging to the group
j) based upon available fundamental information F
t
, which is common knowledge for both groups and all the individual
investors, and is weighted then by the individual parameter
i
.
This structure of individual expectations follows the dual structure which the share market process is embedded in: From
the cognitive viewpoint, investors are confronted with fundamental information fromthe business firm(they invest in) from
one side, and the market pricing from another side. From the financial viewpoint, they are confronted with dividends and
net earnings generated by the business firm, and the capital gains and losses involved in the market trading (see Ref. [38]
for further details). The firms side is subsumed here by the factor F, while the markets side is captured by the price trend
t1

t
(p).
Following Galams specification of the formation of social opinions [17,18], for each side of the Share Exchange (potential
buyers who currently do not hold shares, and potential sellers who hold them) we can define a generic function of their
social mood m
j
t,k
as follows:
m
j
t,k
= f
_
m
j
t,k=0
, k
j
t
, F
t,h
_
, (3)
where the fundamental signal F can influence k
j
t
. For each group j = S, D, m
j
t,k
defines then the density at time t of individual
investors who are confident in the market signal or trend (m 1), while 1 m
j
t,k
defines the density at time t of investors
who distrust that market signal (m 0). The initial value m
j
t,k=0
can be exogenous or endogenous to the model setting. In
particular, it can depend on F and its history.
On this basis, at each time t, we assume that individual investors interact within each group j by subgroups of various
given sizes for a series of successive k sub-periods, in order to generate the group opinion for that time t. This subgroup
Y. Biondi et al. / Physica A 391 (2012) 55325545 5535
interaction is an analytical tool that enables our model to capture the density distribution of market beliefs and its evolution
over time. The subgroups can then be understood as special fields that frame and shape individual opinions. These fields may
relate to tools, methodologies and emerging mindsets and worldviews shared by some investors, as well as to the financial
intermediation structure comprising asset management funds, consultants and brokers with various sizes and influence
abilities Let us take the example of groups of size 3 and 4. In particular, for groups of size 3, the density after k successive
updates is
m
j
t,k
= (m
j
t,k1
)
3
+3(m
j
t,k1
)
2
(1 m
j
t,k1
), (4)
where m
j
t,k1
is the proportion of agents who, at time t, are confident in the market signal at a distance of (k 1) updates
from the initial proportion m
j
t,0
at the same time t. For groups of size 4, the same density writes,
m
j
t,k
= (m
j
t,k1
)
4
+4(m
j
t,k1
)
3
{1 m
j
t,k1
} +6(q
j
)(m
j
t,k1
)
2
{1 m
j
t,k1
)
2
, (5)
where the last term includes the tie case contribution (with two believers confronted with two distrusters) weighted
with the probability q
j
that defines the common degree of confidence in the market trend. Accordingly, in case the group has
doubts, the local four agents become either distrusters with probability (1 q
j
), establishing their common mood (density)
down to 0 or believers with probability q
j
pushing their common mood up to 1.
For a mixture of group sizes n with the probability distribution a
n
under the constraint

L
n=1
a
n
= 1 where L is the
largest group size and n refers to the group size, the above equations become
m
j
t,k
=
L

n=1
a
n
_
_
_
n

j=N[
n
2
+1]
C
n
j
(m
j
t,k1
)
j
(1 m
j
t,k1
)
(nj)
+(q
j
)V(n)C
n
n
2
(m
j
t,k1
)
n
2
(1 m
j
t,k1
)
n
2
_
_
_
, (6)
where C
n
j

n!
(nj)!j!
, N
_
n
2
+1
_
Integer Part of
_
n
2
+1
_
, and V(n) N
_
n
2
_
N
_
n1
2
_
. This implies V(n) = 1 for n even
and V(n) = 0 for n odd. The proportion of distrusters is then 1 m
j
t,k
.
It is worth emphasizing that the Galam model of opinion dynamics tangles up three main mechanisms to produce
a threshold opinion dynamics among two competing choices within an ensemble of investors. The first mechanism is
exogenous and combines all effects which act directly and individually on the investor to influence its own personal choice,
here to trust or distrust the current market price. This mechanism determines the initial share m
j
t,k=0
of investors who
are respectively confident in, or distrusting of that trend. The two other mechanisms are endogenous to the ensemble of
interacting investors.
The second mechanism embeds a social mimetic effect using a local majority rule: investors confront their actual choice
with the ones of a small group of other investors and update their personal choices following the choice which was locally
majority withinthat group. At the collective global level, for groups of oddsizes, this interactive process produces a threshold
dynamics for which the tipping point is located at precisely fifty percent: the choice which starts with an initial support of
more than fifty percent of investors will drive the market along its direction.
The third mechanismis more subtle and depends on the occurrence of a local doubt within an even size group of investors
which have to settle their group opinion. If such a doubt occurs, all the involved investors adopt just the mood which follows
the prevailing common belief about the market price trend. Accordingly, within an ensemble of investors, with m
j
t,k
percent
of themtrusting the market trend, a local doubting group of even size may decide to either trust that trend with a probability
of (q
j
) or distrust it with a probability of (1 q
j
).
The breaking contribution of this leading common belief is to unbalance drastically the threshold dynamics by placing
the tipping point (TP) at a value which can be as low as 15% for the choice which goes along the common belief q
j
, and as
high as 85% for the choice which contradicts that common belief [17,18]. This tipping point TP is a function of the degree of
common belief q
j
and the group size n.
For the case of a group of size 4 used in this work, we have 23% and 77% for the tipping points related to respectively
q
j
= 0 (complete distrust in the market trend) and q
j
= 1 (complete trust). This implies that, at every step k, the group
mood always goes either towards 0 for any m
j
t,k=0
< 0.23 (m
j
t,k
0 with increasing k), or towards 1 when m
j
t,k=0
> 0.77
(m
j
t,k
1 with increasing k).
However, for tipping points between these extreme values, the model determines whether the common belief under
doubt q
j
dominates the group mood m
t,k
as follows,
TP(q
j
) =
1 +6q
j

_
13 36q
j
(1 q
j
)
6(1 +2q
j
)
(7)
with m
j
t,k
0 when m
j
t,k=0
< TP(q
j
) and m
j
t,k
1 when m
j
t,k=0
> TP(q
j
). For the special value m
j
t,k=0
= TP(q
j
) we have
m
j
t,k
= TP(q
j
) for any k. The case q
j
= 1/2 implying a common belief perfectly balanced between trust and distrust - yields
5536 Y. Biondi et al. / Physica A 391 (2012) 55325545
TP(1/2) = 1/2, in between the two extreme cases TP(1) =
5

13
6
0.23 and TP(0) =
1+

13
6
0.77. For a combination
of sizes, the TP can still be calculated using Eq. (7) through numerical computation with 0 TP(q) 1 depending on their
various proportions.
This third mechanism especially illustrates how a common belief shared by some groups of investors can shape
substantially the working of the market pricing over time by influencing the ongoing formation of the collective mood
m [9]. This mechanism also sheds light on the framing and shaping role plaid by aggregating operators (so-called market
makers) such as asset management funds, consultants and brokers with various sizes and influence abilities.
4. The formation of the market clearing price
The formation of the market clearing price p

t+1
over time depends on the aggregation of individual bids of demand and
supply at each period t. In particular, every shareholder (j = S) i wishes to sell if p

t+1
E
t
(p
t+1
)|
S
i
, while every potential
buyer (j = D) i wishes to buy if p

t+1
E
t
(p
t+1
)|
D
i
. By assuming uniform distribution of individual investors within each
group j = S, D, the individual price expectation E
t
(p
t+1
)|
j
i
of investor i belonging to group j can be rewritten as a function
of expectations expressed by investors i = 0 and i = 1 defined as follows:

t
|
j
0

_
E
t1
(p
t
)|
j
0
p
t
_

t
|
j
1

_
E
t1
(p
t
)|
j
1
p
t
_
.
Individual price expectation by investor i may then be described as follows:
E
t
(p
t+1
)|
j
i
= p
t
+m
j
t,k
(p
t
p
t1
)
_

j
0
(1
i
)
j
0,t
+
j
1

j
1,t
_
+
i

j
F
t
. (8)
Aggregated demand and supply are now defined by the focal prices of four representative agents with i = 0 and
i = 1 j = S, D. By defining:
P
j
t
max arg
_
E
t
(p
t+1
)|
j
i=0
; E
t
(p
t+1
)|
j
i=1
_
P
j
t
min arg
_
E
t
(p
t+1
)|
j
i=0
; E
t
(p
t+1
)|
j
i=1
_
,
the aggregate functions of supply x
S
t+1
and demand x
D
t+1
integrate individual bids as follows:
_

_
x
S
t+1
=
_
p

t+1
P
S
t
1
P
S
t
P
S
t
dx
x
D
t+1
=
_
P
D
t
p

t+1
1
P
D
t
P
D
t
dx
(9)
or, equivalently:
x
S
t+1
=
_
_
_
_
_
0 if p

t+1
P
S
t
p

t+1
P
S
t
P
S
t
P
S
t
if P
S
t
< p

t+1
< P
S
t
1 if p

t+1
P
S
t
(10)
x
D
t+1
=
_
_
_
_
_
_
1 if p

t+1
P
D
t
P
D
t
p

t+1
P
D
t
P
D
t
if P
D
t
< p

t+1
< P
D
t
0 if p

t+1
P
D
t
.
(11)
The necessary condition for the existence of a market clearing price p

t+1
(implying that both demand and supply are
different from zero) is
P
S
t
p

t+1
P
D
t
. (12)
This condition implies two different scenarios:
Y. Biondi et al. / Physica A 391 (2012) 55325545 5537
1. if P
D
t
P
S
t
, there is no matching between demand and supply; therefore, no exchange transactions occur, and the Share
Exchange does not fix any updated clearing price at period t; at the next period t +1, investors will then observe a special
no-clearing price p
NC
generated by the market-making process according to some external rule or device;
2. if P
D
t
> P
S
t
, there is matching, and the market clearing price p
C
is defined as the price that makes demand equal to supply.
2
On this basis, the market clearing price at period t is
p

t+1
=
_
p
NC
if P
D
t
P
S
t
p
C
if P
D
t
> P
S
t
.
(13)
Let assume that the no-clearing price p
NC
is fixed according to the following rule:
p
NC
= p
t
+, (14)
where is the smallest tick value available on the Share Exchange. Furthermore, concerning the clearing price p
C
, demand
is equal to supply if
p
C
P
S
t
P
S
t
P
S
t
=
P
D
t
p
C
P
D
t
P
D
t
, implying that (15)
p
C
=
P
D
t
_
P
S
t
P
S
t
_
+P
S
t
_
P
D
t
P
D
t
_
_
P
D
t
P
D
t
_
+
_
P
S
t
P
S
t
_ . (16)
Therefore, the market clearing price p

t+1
at time t is:
p

t+1
=
_

_
p
NC
= p
t
+ if P
D
t
P
S
t
p
C
=
P
D
t
_
P
S
t
P
S
t
_
+P
S
t
_
P
D
t
P
D
t
_
_
P
D
t
P
D
t
_
+
_
P
S
t
P
S
t
_ if P
D
t
> P
S
t
.
(17)
5. The dynamics of the market clearing price
In order to analyze the dynamics of the market clearing price (when it exists, i.e., p

t+1
= p
C
) over time, let us define
j = S, D:
P
j
(n)
t

n=1
_

j
0
_
n
_
p
tn
+m
j
tn
(p
tn
p
tn1
) p
tn+1
_
F
j
(n)
t

n=0
__

j
0
_
n _

j
F
tn
_
_
L
j
(P (n) , F (n))
_
_
_
_

j
1

j
0
_
P
j
(n) +F
j
(n)

j=S,D

j
1

j
0
_
P
j
(n) +F
j
(n)

_
1
M
j
(P (n) , F (n))
_

j
1

j
0
_
P
j
(n) +F
j
(n) .
Accordingly,
E
t
(p
t+1
)|
j
i
= p
t
+m
j
t,k
(p
t
p
t1
) +
j
0
P
j
(n) +
i
M
j
(). (18)
The four representative agents are then described as follows:
j = S, D with
i
= 0 : E
t
(p
t+1
)|
j
i=0
= p
t
+m
j
t,k
(p
t
p
t1
) +
j
0
P
j
(n)
j = S, D with
i
= 1 : E
t
(p
t+1
)|
j
i=0
= p
t
+m
j
t,k
(p
t
p
t1
) +
j
1
P
j
(n) +F
j
(n) .
2
The Walrasian auction is included by this scenario when the whole share offer is satisfied.
5538 Y. Biondi et al. / Physica A 391 (2012) 55325545
By computation, the market clearing price function can be rewritten as follows:
p

t+1
= p
t
+

j=S,D
_
_
_
m
j
t
(p
t
p
t1
) +P
j
()
_
L
j
()
_
_
+
_

_
_
M
D
()
L
S
()
_
if M
j
() > 0 j
_
M
S
()
L
D
()
_
if M
j
() < 0 j

j=S,D
_
M
j
()
L
j
()
_
if M
D
() > 0
and M
S
() < 0
0
if M
D
() < 0
and M
S
() > 0.
(19)
Accordingly, the pattern of market clearing price p

t+1
is based on the historical price p
t
by adding two further elements.
The first element comprises (for both j = S and j = D) two sub-elements:
the numerator, m
j
t,k
(p
t
p
t1
)+P
j
(n), is independent fromsignal F
t
anddependent onthe price trend
t
(p

) weighted
3
by the current group mood m
j
t
and its weighted past series P
j
(n).
the denominator, L
j
(), depends on both F
j
(n) which represents the weighted fundamental signal trend series, and P
j
(n)
which represents the weighted market price trend series; for each group j, this sub-element weights the contribution of
the price trend series to the formation of the market clearing price at time t.
The second element depends on both weighted past series F
j
() and P
j
(). In particular, if M
j
() is positive (negative) for
bothgroups, thenthis element increases (decreases) the market clearing price. Moreover, if M
j
() is negative for shareholders
(j = S) while it is positive for potential investors (j = D), then the divergence between groups is mutually balanced on the
marketplace. On the contrary, if M
j
() is positive for shareholders while negative for potential investors, then the divergence
makes the whole element equal to zero.
In sum, the formation of share prices over time depends respectively on the dynamics of the fundamental signal F from
one side, and the dynamics of the clearing market price p from another side. Both dynamics are shaped by the ongoing
evolution of individual and group opinions (and related bids) captured by the structure of the model.
6. The results of the model
Previous literature has identified stylized facts of market price series dynamics such as fat-tailed distribution of absolute
returns that experience long-memory and persistence, and the distribution of their autocorrelation function that decays
rapidly to zero, both distributions being then described by power laws. These facts are interesting and relate to some
statistical measurements of properties of the price series alone. They refer indeed to a technical notion of financial market
efficiency. Even though this paper does not purport to address these facts specifically, our model is consistent with them.
Under appropriate calibration, it can reproduce power laws of absolute returns and their autocorrelation function, both
showing exponents of the same magnitude as empirical series of share market prices [3942].
Nevertheless, our model further raises the different question of whether the formation of the market prices over time
evolves in line with overarching fundamentals. This question refers to a substantial notion of financial market efficiency that
is less investigated by current streams of research. The distinction between technical and substantial notions of financial
market efficiency have been investigated extensively [4345].
Descriptive analyses may be empirically satisfying, and may even forecast future states of the financial system well, but
they do not provide any theoretical explanation of why market price fluctuations arise. However, our model links such
fluctuations to shifting socio-economic conditions of an underlying ensemble of investors and structures. This theoretical
approachmay constitute the beginning of a useful model to better understandmarket price movements over socio-economic
time and space. In particular, our model quantizes the possible strategies of individual investors into two polar behaviors
shaped by two distinctive signals: the market trend, and the fundamental price of reference. Both signals belong to the
information set and modify the payoffs available to every investor. While the fundamental price is exogenous to the model,
the other conditions are endogenously generated through the dynamics of interacting agents that influence each other.
On this basis, the model can help to explain whether and whenever the market price movements are in line with the
fundamental price dynamics.
Our model cannot be solved analytically and thus requires some numerical treatment to extract its main results. This
goal is implemented here by using a series of characterizing cases which exhibit the major results of the model. For this
purpose, let us assume that
j
i
= and
j
= j = S, D and i. This specification implies that group heterogeneity is
captured by the group mood m
j
t,k
and leads to the following statement: If
j
i
= and
j
= j = S, D and i, the group
3
Remember that m
j
t,k
1 implies full weight to this information in order to build individual price expectations. The mood m can be influenced by the
fundamental signal F, and is the final result of the dynamic interaction within the group j for k steps occurring between t 1 and t.
Y. Biondi et al. / Physica A 391 (2012) 55325545 5539
mood m
j
t,k
subsumes all the group heterogeneities between demand and supply; then, there exists only one market clearing price
case instead of the four cases defined above.
In particular, the individual price expectation function becomes:
E
t
(p
t+1
)|
j
i
= p
t
+m
j
t,k
(p
t
p
t1
) +
t

n=1
_
()
n
_
p
tn
m
j
tn
(p
tn
p
tn1
) p
tn+1
__
+
i
t

n=0
_
()
n
( F
tn
)
_
or E
t
(p
t+1
)|
j
i
= p
t
+m
j
t,k
(p
t
p
t1
) +P
j
(n) +
i

j
F
j
(n) .
Concerning the formation of the market clearing price, for
j
i
= i, j, L
j
() = 2. Therefore, closer are
j
i
i, j, closer
is L
j
() to 2, implying that the whole first element of Eq. (19) tends to become independent from the fundamental signal
series F
j
(n). Furthermore, when
j
1
,
j
0
=
j
, M
j
() = F
j
(n) j: Closer are
j
0
and
j
1
j, closer is M
j
() to F
j
(n) that is
independent from the market price trend series P
j
(n). Therefore, this specification clearly distinguishes the dual structure
of the market clearing price dynamics which is driven by two distinct factors: the market signal or trend
t
(p

) weighted
by the evolution of groups market sentiments, and the fundamental signal F. The market clearing price becomes:
p

t+1
= p
t
+
1
2

j=S,D
_
m
j
t,k
(p
t
p
t1
) +P
j
(n)
_
+
_
F (n)
2
_
(20)
where
P
j
(n)
t

n=1
()
n
_
p
tn
+m
j
tn
(p
tn
p
tn1
) p
tn+1
_
F (n)
t

n=0
_
()
n
( F
tn
)
_
.
Accordingly, the dynamics of the market clearing price (when it exists) is denoted as follows:

t+1
_
p

_
p
t+1
p
t
= f
_

t
_
p

_
, m
j
t,k
_
+g (F (n)) . (21)
This price pattern comprises two different elements. The first element, f
_

t
(p

) , m
j
t,k
_
, is a group factor that depends
on the market signal
t
(p

) weighted by the group mood m

j
t,k
that is collectively assigned to the market price trend by
group j at time t. The second element, g (F (n)) =
F(n)
2
, depends on the weighted trend of the fundamental signal F
t
,
with F
j
(n) = F
D
(n) = F
S
(n) in this particular specification. Consequently, if F (n) is positive (negative), then g (F (n))
proportionally increases (decreases) the market clearing price at time t.
This specification of the model polarizes the formation of market prices over time between market sentiment and
fundamental signal, which interact over time in a non trivial way. Market sentiment may then reduce, amplify or contradict
the impact of the ongoing fundamental signal on market pricing according to occurred configurations generated by their
interacting dynamics. This theoretical result describes the endogenous formation of market prices, and improves on
approaches that assume their exogenous existence in order to model market exuberance.
The rest of the section presents various possible scenarios exhibited by this reduced form of our model. The evolution of
the fundamental signal is exogenous to the model and is simulated as an external parameter, according to some stochastic
dynamics. Such simulations are illustrations of the model and should not be confused with a Monte Carlo simulation of the
system. Here only one fundamental signal series is simulated, while all other mechanisms obey their respective equations
according to the chosen set of scenario parameters.
More precisely, let define the fundamental price series based upon the accumulation of fundamental signals as follows:
p
F
t
= p
F
t1
+F
t1
= p
0
+
t1

n=0
F
n
, (22)
where, by assumption, the initial share price p
0
= p
t=0
and the initial fundamental price p
F
t=0
are equal, and

F
t
0
(implying that p
F
t
0). By construction, the reduced form of our model aligns fundamental price and share market price
dynamics when all the parameters are symmetric between demand and offer and group interaction is absent (k = 0). This
case illustrates a perfectly balanced financial systemwhere m
S
t,k=0
= m
D
t,k=0
= 1/2 and, for groups of size 4, q
S
= q
D
= 1/2.
The tipping point TP is then equal to 1/2 independently of the group size. This set of heroic assumptions implies a
straightforward formation of individual and group opinions perfectly balanced between chartism and fundamentalism,
demand and supply, actual and potential shareholders at every points of time {k, t, h}. This also implies that no group
5540 Y. Biondi et al. / Physica A 391 (2012) 55325545
Fig. 1. Series of fundamental signal p
F
t
and market clearing price p
t,k
as a function of time with 0 t 500 without group interaction (k = 0).
F
t
= U(0; 1) U(0; 1) follows a stochastic pattern t 1. The parameters are set to values
j
i
= = 0.5,
j
= = 1, = 0.01, p
0
= 10, m
S
t,k=0
=
0.4, m
D
t,k=0
= 0.4,
t=0
|
j
i
= 0.1 (U(0; 1) U(0; 1)), j = S, D and i.
dynamics is involved in market pricing over time. In this context, our model shows a market price formation pattern
that remains ever and ever in line with the evolution of fundamentals generated by the underlying business firm, those
fundamentals being common knowledge between all investors.
In the following, we shall illustrate several scenarios at variance with this case. Let assume that the fundamental signal
experiences a random pattern: F
t
= U(0; 1) U(0; 1) t 1. For sake of comparability, all scenarios are simulated under
the same stochastic fundamental signal pattern, and assume:
j
i
= = 0.5;
j
= = 1; = 0.01; p
0
= 10; F
0
=
0; m
S
t,k=0
= 0.4; m
D
t,k=0
= 0.4;
t=0
|
j
i
= 0.1 (U(0; 1) U(0; 1)), j = S, D and i.
6.1. Illustrative scenarios
On the basis of the baseline set of parameters, absent group interaction (k = 0), the reduced formof our model generates
a market price dynamics related to the exogenously selected stochastic pattern of fundamental signals (Fig. 1).
The overall co-evolution of both series shows not only temporal sequences (series of periods t) when market prices
connects with fundamental prices, but also sequences when the formers spontaneously moves away from the latter,
endogenously generating market exuberance and market disconnection. This latter phenomenon is the most insightful,
since it shows as the market price dynamics may persistently remain apart from the fundamentals dynamics of reference
(from the statistical viewpoint, the respective averages are then significantly different for a long while).
Following existing empirical literature [39], we define returns on the market price series as the relative price change at
various time scales, and absolute returns as follows:
|r

t
(t)| =
|p
t+
t
p
t
|
p
t
with
t
= 1. (23)
Accordingly, we analyze the complementary cumulative distribution (density function) of absolute returns:
P(|r

t
(t)| > y) ay
x
with
t
= 1. (24)
Available empirical evidence shows that, at different time scales, this distribution follows a power law with exponent
2 < x 4 that is outside the stable Levy regime requiring x < 2. Following [39], we verify that market price series of
baseline scenario as Fig. 1 fits a power law with exponent x
1
= 1.10561 for lower orders, and x
2
= 3.30276 for higher
orders of absolute returns, in line with empirical evidence (Fig. 2).
We further analyze the autocorrelation function C
i
(t) of those returns (sampled at
t
= 1), defined as follows:
C
i
(t) =

r
t
r
t+i
p
t

2
p
2
t
p
t

for 1 < i < 1000. (25)

Accordingly, we analyze the complementary cumulative distribution (density function) of the above autocorrelation
function:
P(C
i
(t) > y) ay
x
. (26)
Available empirical evidence shows that, at different time scales, this distribution follows a power law with exponent
0.1 < x < 0.3. Following [39], we verify the autocorrelation function distribution of the market price series of baseline
scenario as Fig. 1 fits a power law with exponent x
3
= 0.177136, in line with empirical evidence (Fig. 3).
Y. Biondi et al. / Physica A 391 (2012) 55325545 5541
Fig. 2. LogLog plot of the complementary cumulative distribution of absolute returns |r
t
(t)| =
|p
t+
t
pt |
pt
with
t
= 1 for the baseline scenario as Fig. 1.
Power-law regression fit gives an exponent of x
1
= 1.10561 in the lower order region, and x
2
= 3.30276 in the higher order region.
Fig. 3. LogLog plot of the autocorrelation function sampled at = 1 for returns C
i
(t) =

(rt r
t+i
pt
2
)
p
2
t
pt
2

for 1 < i < 1000; power-law regression fit gives

an exponent of x
3
= 0.177136, in line with empirical evidence. Note that, after some hundred periods, the correlations reach the noise level.
Furthermore, we analyze the impact of groupinteraction(market sentiment dynamics) baseduponthis baseline scenario.
In particular, the group interaction concerns groups of size 3 in Fig. 4, and various characteristic configurations for groups
of size 4 with q
D
= q
S
= 0.3 in Fig. 5, q
D
= q
S
= 0.7 in Fig. 6, q
D
= 0.7, q
S
= 0.3 in Fig. 7. By symmetry the same Fig. 7
holds for q
D
= 0.3, q
S
= 0.7. In case of group indeterminacy, the probability q
j
decides whether the group belief tends to
trust the market or not. In particular, since 0.23 < m
t,k=0
< 0.77, the group mood m
t,k
tends to 1 if TP(q
j
) > m
t,k=0
(mood
dominance), while it tends to 0 if TP(q
j
) < m
t,k=0
(common belief dominance). Under our assumptions, TP(q
j
= 0.3) = 0.36
and TP(q
j
= 0.70) = 0.64, while m
t,k=0
= 0.4 for both populations of shareholders (j = S) and investors (j = D) in all
periods t.
We perform simulations for periods from t = 1 to t = 500, with various k fixed respectively at 0, 3 and 6. In all
simulations, the market clearing price and the fundamental signal do change at the same rhythm t, while the market
5542 Y. Biondi et al. / Physica A 391 (2012) 55325545
Fig. 4. Fundamental signal p
F
t
and market clearing price p
t,k
for respectively k = (0, 3, 6) as a function of time with 0 t 500 using groups of size 3. F
t
follows a stochastic trend (same as the one in Figs. 1 and 57). The parameters are set to values
j
i
= = 0.5,
j
= = 1, = 0.01, p
0
= 10, m
S
t,k=0
=
0.4, m
D
t,k=0
= 0.4,
t=0
|
j
i
= 0.1 (U(0; 1) U(0; 1)), j = S, D and i.
Fig. 5. Fundamental signal p
F
t
and market clearing price p
t,k
for respectively k = (0, 3, 6) as a function of time with 0 t 500 using groups of size 4
with q
D
= q
S
= 0.3. F
t
follows a stochastic trend (same as the one in Figs. 1, 4, 6 and 7). The parameters are set to values
j
i
= = 0.5,
j
= = 1, =
0.01, p
0
= 10, m
S
t,k=0
= 0.4, m
D
t,k=0
= 0.4,
t=0
|
j
i
= 0.1 (U(0; 1) U(0; 1)), j = S, D and i.
sentiment changes at its rhythm k from 0 (no steps, implying no change from the initial value) to 6 (six steps between
t 1 and t). It is worth emphasizing that the whole population for both shareholders (j = S) and investors (j = D) being
normalized to one, the number and size of groups are treated as proportions and probabilities. Therefore the actual total size
of the population is irrelevant providing it is large enough to allow the use of probabilities. Figs. 47 illustrate the results
using those probabilities.
The simulations show that changes in the market sentiment (captured by the interactive steps k) exacerbate the market
exuberance aroundthe pathprovidedby the fundamental price p
F
t
over time. The evolving market sentiment either amplifies
or reduces the relative change driven by the fundamental signal. In some cases or sequences, market sentiment may even
generate a peculiar market price dynamics that is somewhat disconnected from fundamentals in a non-trivial way. This
latter result is counterintuitive, implying that the formation of a market clearing price over time is not sufficient to assure
that market pricing is aligned on the fundamental price that arises from fundamentals that are common knowledge among
heterogeneous market participants. It may be interesting to further analyze in which conditions such a case emerges. In
sum, the resulting market price does under- or over-valuate the shares relative to their fundamental price. This result is in
line with theoretical and empirical analyses of market exuberance discussed by Refs. [4648] among others.
7. Conclusive remarks
Our model considers the imbrications of three different interlocked levels which are all essential to the dynamics of the
price formation. These levels change at different rhythms. From one side, the fundamental signal has the slowest rhythm or
the largest duration h, while, from another side, the social mood is driven by the quickest rhythm or the shortest duration
k. In-between stands the market clearing price that changes at each period of the basic time unit t.
This hierarchically ordered frame sheds a novel light on the complexity of the interplay between objective and
subjective drivers whichintervene insecurity price formation. Onone hand, the model reproduces some expectedbehaviors,
Y. Biondi et al. / Physica A 391 (2012) 55325545 5543
Fig. 6. Fundamental signal p
F
t
and market clearing price p
t,k
for respectively k = (0, 3, 6) as a function of time with 0 t 500 using groups of size 4
with q
D
= q
S
= 0.7. F
t
follows a stochastic trend (same as the one in Figs. 1, 4, 5 and 7). The parameters are set to values
j
i
= = 0.5,
j
= = 1, =
0.01, p
0
= 10, m
S
t,k=0
= 0.4, m
D
t,k=0
= 0.4,
t=0
|
j
i
= 0.1 (U(0; 1) U(0; 1)), j = S, D and i.
Fig. 7. Fundamental signal p
F
t
and market clearing price p
t,k
for respectively k = (0, 3, 6) as a function of time with 0 t 500 using groups of size 4
with q
D
= 0.7, q
S
= 0.3. F
t
follows a stochastic trend (same as the one in Figs. 1 and 46). The parameters are set to values
j
i
= = 0.5,
j
= =
1, = 0.01, p
0
= 10, m
S
t,k=0
= 0.4, m
D
t,k=0
= 0.4,
t=0
|
j
i
= 0.1 (U(0; 1) U(0; 1)), j = S, D and i. The same Figure holds for q
D
= 0.3, q
S
= 0.7.
like the long-term connection between market pricing and overarching fundamentals, but, on another hand, it is further
capable to single out cases where totally unexpected behavior is observed when the market price disconnects from
fundamental signal over time. Both results are obtained endogenously, while the same mechanisms are at work in those
opposite situations. In this way, our theoretical model points out some underlying conditions that can help to explain
whether and whenever the market price movements evolve in tune with fundamental price dynamics.
Financial economic models often assume that investors know(or agree on) the fundamental value of the firms securities
that are traded, easing the passage from the individual to the collective dimension of the financial system generated by
the Share Exchange over time. Our model relaxes that heroic assumption of one unique true value and deals with the
formation of share market prices through the dynamic formation of individual and social opinions (or beliefs) based upon
a fundamental signal of economic performance and position of the firm, the forecast revision by heterogeneous individual
investors, and their social mood or sentiment about the ongoing state of the market pricing process. Market clearing price
formation is then featured by individual and group dynamics that make its collective dimension irreducible to its individual
level.
This dynamic holistic approach provides a better understanding of the market exuberance generated by the Share
Exchange over time. This exuberance depends not only on individual biases or mistakes, but also on dynamic and collective
dimensions that arise from the interaction of individuals among them and with evolving collective structures over time.
Our model captures this collective dimension through the evolution of available common knowledge on the economic
performance and position of the firm (fundamental or firm-specific information), as well as through the evolving social
mood or sentiment on the current state of the market (or the industry, or the whole economy). While the former can be
related to information release by accounting for reporting and disclosure, the latter can be related to investors confidence
and financial analysts consensus, and their respective evolution over socio-economic time and space where the financial
market is embedded.
5544 Y. Biondi et al. / Physica A 391 (2012) 55325545
Appendix
For sake of completeness, we provide here various other versions of the market price equation. Starting fromEq. (19), let
us define:

M
S

M
S

M
D

= L
S
(P (n) , F (n))
1
(1
t
)

M
D

M
S

M
D

= L
D
(P (n) , F (n))
1
with M
j
() =
_

j
1

j
0
_
P
j
(n) +F
j
(n) =
_

j
1

j
1,t

j
0

j
0,t
_
+
j
F
t
.
Or, equivalently:

t
=

S
1

S
0
_
t

n=1
_
_

S
0
_
n
_
p
tn
+m
S
tn
(p
tn
p
tn1
) p
tn+1
_
_
+
t

n=0
_
_

D
0
_
n
_

D
F
tn
_
_

j=S,D

j
1

j
0
_ t

n=1
__

j
0
_
n
_
p
tn
+m
j
tn
(p
tn
p
tn1
) p
tn+1
__
+
t

n=0
__

j
0
_
n _

j
F
tn
_
_

and
(1
t
) =

D
1

D
0
_
t

n=1
_
_

D
0
_
n
_
p
tn
+m
D
tn
(p
tn
p
tn1
) p
tn+1
_
_
+
t

n=0
_
_

D
0
_
n
_

D
F
tn
_
_

j=S,D

j
1

j
0
_ t

n=1
__

j
0
_
n
_
p
tn
+m
j
tn
(p
tn
p
tn1
) p
tn+1
__
+
t

n=0
__

j
0
_
n _

j
F
tn
_
_

.
Therefore, the market clearing equation can be rewritten as follows:
p

t+1
= p
t
+
t
m
D
t
(p
t
p
t1
) +(1
t
) m
S
t
(p
t
p
t1
) +
t
_

D
0

D
0,t
_
+(1
t
)
_

S
0

S
0,t
_
+
_

t
__

D
1

D
1,t

D
0

D
0,t
_
+
D
t
F
t
_
if M
j
> 0
(1
t
)
__

S
1

S
1,t

S
0

S
1,t
_
+
S
t
F
t
_
if M
j
< 0

t
__

D
1

D
1,t

D
0

D
0,t
_
+
D
t
F
t
_
+
(1
t
)
__

S
1

S
1,t

S
0

S
1,t
_
+
S
t
F
t
_
if M
D
> 0
and M
S
< 0
0
if M
D
< 0
and M
S
> 0.
Or, equivalently:
p

t+1
= p
t
+
t
m
D
t
(p
t
p
t1
) +(1
t
) m
S
t
(p
t
p
t1
)
+
t
t

n=1
_
_

D
0
_
n
_
p
tn
+m
D
tn
(p
tn
p
tn1
) p
tn+1
_
_
+ (1
t
)
t

n=1
_
_

S
0
_
n
_
p
tn
+m
S
tn
(p
tn
p
tn1
) p
tn+1
_
_
+
_

t
_
M
D
()
_
if M
j
> 0 j
(1
t
)
_
M
S
()
_
if M
j
< 0 j

t
_
M
D
()
_
+(1
t
)
_
M
S
()
_
if M
D
> 0
and M
S
< 0
0
if M
D
< 0
and M
S
> 0.
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