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We study the effect of overconfidence on price dynamics in a Brock-Hommes asset pricing model.Overconfidence is modeled as a misperception of risk affecting trend-following traders.We show that this mechanism shrinks the stability region of the fundamental equilibrium and induces endogenous oscillations.A bifurcation analysis and stochastic simulations illustrate how overconfidence amplifies volatility and mispricing.
Fabio Tramontana (Mon,) studied this question.