Application of Game Theory to Stock Market Simulation

Game Theory- A General Idea

All situations in which an agent can only act to his utility through anticipating the responses to his actions by other agents is known as a GAME. Agents have competing interests to maximize their own share which requires anticipation of rival response. This expectation is not perfect so uncertainty is the necessary feature of the game.

Stock Markets
Stock markets fluctuations are, in general, based on the following factors: Clash of strategies devised by firms in the same industry. Investment in a firm by people, based on the performance, perceptions, history and beliefs. We would like to focus on these aspects using Game Theory.

Applications
Let us assume: There are two firms, A and B, which are in the same competitive market. These are the paths that can be taken by A: 1. Launch a new product ( Rate of success expected = a1 ) 2. Research the market and redevelop its existing products( a2 ) 3. Reduction in prices( a3 ) In response, B can also take steps to counter As policies. 1. Launch a new product itself( Rate of success expected = b1 ) 2. Distribute its profit among shareholders to retain market share( b2) 3. Further reduce its prices( b3)

b1 b2 b3

a1 a2 a3

As success as seen by B: a1(1- b1) = a2(1-b2) = a3( 1-b3) we know b1+b2+b3 = 1 After calculation: b1= (a1/a3 + a1/a2 - 1) / (a1/a2 +a1/a3 + 1) b2= (a2/a3 + a2/a1 - 1) / (a2/a1 + a2/a3 + 1) b3= (a3/a2 + a3/a2 - 1) / (a3/a1 + a3/a2 + 1)

Therefore, B can weight its choices and then, assuming both of the players are equally rational, take a decision that is most likely to be undermining As strategy. In this case we have taken the game to be a Zero sum game i.e. if one of the players lose the other one wins an equal amount.
These decisions taken by the companies finally decide the situation of the market and thus have a bearing on the respective stock values.

The other way, stock market variations occur: Let us assume that there is an investor who has 2 companies in mind and wants to invest in one of them. He knows about the previous performance of all the companies and knows the shortcomings and losses that can occur. Let the utility function be Q= u(1) Q is the expected return from 1st company W= maximizing Probability of best outcome L= minimizing Probability of worst outcome The investor is indifferent in getting Q OR W from another company with probability u(1) and L from it with probability 1 u(1). Therefore the attitude to risk comes into play.