Bubbles and crashes: Gradient dynamics in financial markets

Fund managers respond to the payoff gradient by continuously adjusting leverage in our analytic and simulation models. The base model has a stable equilibrium with classic properties. However, bubbles and crashes occur in extended models incorporating an endogenous market risk premium based on investors' historical losses and constant-gain learning. When losses have been small for a long time, asset prices inflate as fund managers increase leverage. Then slight losses can trigger a crash, as a widening risk premium accelerates deleveraging and asset price declines. (C) 2008 Elsevier B.V. All rights reserved.