PRIVATE INFORMATION ACQUISITION IN EXPERIMENTAL MARKETS PRONE TO BUBBLE AND CRASH

This paper reports the results of twelve experimental markets designed to investigate whether a costly private information system decreases the propensity of price bubbles to form. A private information system is hypothesized to decrease traders' subjective uncertainty about the behavior of other traders by reinforcing common expectations for all traders. Results show that private information does not eliminate price bubbles, but asset prices converge toward the rational expectations predictions with trader experience. The price of private information is related to the expected gains derived from asset trading.     

Credit Availability and Asset Pricing Dynamics in Illiquid Markets: Evidence from Commercial Real Estate Markets

This article examines credit frictions and asset pricing in public and private markets with varying liquidity. We find that a tightening in credit availability is negatively related to subsequent price movements in private and public commercial real estate markets. Assets trading in illiquid segments of these markets are also susceptible to a feedback effect whereby changes in asset prices predict subsequent changes in credit availability. Controlling for investor demand, our findings suggest credit constraints play an economically significant asset pricing role in markets that are both highly levered and relatively illiquid.     

Statistical mechanics of asset markets with private information

Traders in a market typically have widely different, private information on the return of an asset. The equilibrium price of the asset may reflect this information more accurately if the number of traders is large enough compared to the number of the states of the world that determine the return of the asset. We study the transition from markets where prices do not reflect the information accurately into markets where it does. In competitive markets, this transition takes place suddenly, at a critical value of the ratio between number of states and number of traders. The Nash equilibrium market behaves quite differently from a competitive market even in the limit of large economies.     

Do market prices reveal the decision models of sophisticated investors?: Evidence from the laboratory

If security prices are fully revealing, then all public information should be reflected in prices, and unsophisticated traders may be able to learn how various types of information affect security valuation by observing prices. A series of laboratory asset markets was conducted to examine whether unsophisticated traders are able to learn to evaluate publicly released information by trading with and observing trades made by a sophisticated trader who knows the valuation implications of the information. We find that unsophisticated traders who participate in an asset market with a sophisticated trader show significant improvement in their ability to use public information on a subsequent price estimation task. Conversely, a control group consisting only of unsophisticated traders shows no improvement. We conclude that market prices convey the sophisticated trader’s private information in a manner that permits unsophisticated investors to learn the stock price implications of a public information release.     

What Makes Circuit Breakers Attractive to Financial Markets? A Survey

After the stock market crash of October 1987, the Brady Report (1988) and several academic researchers suggested the imposition of "circuit breakers" to prevent the market from fluctuating excessively. Most financial markets in the world have imposed circuit breaker systems, in the form of price limits and trading halts, in an attempt to reduce excessive market volatility. Similar to any other regulations, circuit breakers have proponents and opponents. In this survey, we analyze the benefits and costs of each type of circuit breaker, provide existing theoretical models and predictions related to each type of circuit breaker, and present findings from empirical studies to justify or disqualify the existence of circuit breakers. In addition, we synthesize existing studies and offer directions for further research in this area.     

A Test of the Modigliani‐Miller Invariance Theorem and Arbitrage in Experimental Asset Markets

Modigliani and Miller show that the total market value of a firm is unaffected by a repackaging of asset return streams to equity and debt if pricing is arbitrage‐free. We investigate this invariance theorem in experimental asset markets, finding value‐invariance for assets of identical risks when returns are perfectly correlated. However, exploiting price discrepancies has risk when returns have the same expected value but are uncorrelated, in which case the law of one price is violated. Discrepancies shrink in consecutive markets, but persist even with experienced traders. In markets where overall trader acuity is high, assets trade closer to parity.     

Price volatility,welfare, and trading hours in asset markets

This paper studies the consequences of opening asset markets more often for the properties of asset prices and social welfare. For all reasonable parameter values, increasing trading hours lowers average asset prices, increases unconditional asset price volatility at a given point in time, and decreases unconditional asset price volatility when averaged over the period of time that includes the additional hours that markets are open. Unconditional social welfare is increased by opening markets more often, although the welfare gains are small – well below 1% of lifetime consumption. In contrast, because expanding hours of trading affects agents' information sets, the welfare effect of more trading hours conditional on information available to agents can be large and the effect can be negative.     

The Effect of Sequential Information Arrival on Asset Prices: An Experimental Study

A complete understanding of security markets requires a simultaneous explanation of price behavior, trading volume, portfolio composition (ie., asset allocation), and bid-ask spreads. In this paper, these variables are observed in a controlled setting—a computerized double auction market, similar to NASDAQ. Our laboratory allows experimental control of information arrival—whether simultaneously or sequentially received, and whether homogeneous or heterogeneous. We compare the price, volume, and share allocations of three market equilibrium models: telepathic rational expectations, which assumes that traders can read each others minds (strong-form market efficiency); ordinary rational expectations, which assumes traders can use (some) market price information, (a type of semi-strong form efficiency); and private information, where traders use no market information. We conclude 1) that stronger-form market models predict equilibrium prices better than weaker-form models, 2) that there were fewer misallocation forecasts in simultaneous information arrival (SIM) environments, 3) that trading volume was significantly higher in SIM environments, 4) and that bid-ask spreads widen significantly when traders are exposed to price uncertainty resulting from information heterogeneity.     

The Informational Efficiency of the Equity Market As Compared to the Syndicated Bank Loan Market

The loan market is a hybrid between a public and a private market, comprised of financial institutions with access to private information about borrowing firms. We test whether this is reflected in informationally efficient price formation in the loan market vis-a-vis the equity markets, and reject this private information hypothesis. We also reject a liquidity hypothesis which suggests that equity markets always lead loan markets, despite bank lenders' access to private information, because of greater liquidity in equity markets. We further test, and reject, an asymmetric price reaction hypothesis that states that loan returns are more sensitive to negative information whereas equity returns respond symmetrically to both positive and negative information. We find evidence most consistent with an integrated markets hypothesis that suggests that both the equity and syndicated bank loan markets are highly integrated such that information flows freely across markets. This is particularly true when the equity market makers are also loan syndicate members.      

News‐Specific Price Discovery in Credit Default Swap Markets

We examine the lead and lag relation between equity and credit default swap (CDS) markets. We find that price discovery in equity markets only leads CDS markets following aggregate positive news and not so following other news. While difficult to reconcile with standard asset pricing theories, asymmetric price adjustment is common in goods markets, arising from intermediary power. We provide an explanation for this asymmetry based on dealers exploiting informational advantages vis‐à‐vis investors with hedging motives. Consistent with this explanation, we find that the patterns we document are related to firm‐level proxies for hedging demand, as well as economy‐wide measures of information asymmetries.     

Presidential Address: Liquidity and Price Discovery

This paper examines the implications of market microstructure for asset pricing. I argue that asset pricing ignores the central fact that asset prices evolve in markets. Markets provide liquidity and price discovery, and I argue that asset pricing models need to be recast in broader terms to incorporate the transactions costs of liquidity and the risks of price discovery. I argue that symmetric information‐based asset pricing models do not work because they assume that the underlying problems of liquidity and price discovery have been solved. I develop an asymmetric information asset pricing model that incorporates these effects.     

Cross‐Asset Speculation in Stock Markets

In practice, heterogeneously informed speculators combine private information about multiple stocks with information in prices, taking into account how their trades influence the inferences of other speculators via prices. We show how this speculation causes prices to be more correlated than asset fundamentals, raising price volatility. The covariance structure of asset fundamentals drives that of prices, while the covariance structure of liquidity trade drives that of order flows. We characterize how speculator profits vary with the distributions of information and liquidity trade across assets and speculators, and relate the cross‐asset factor structure of order flows to that of returns.     

The Effect of Short Selling on Bubbles and Crashes in Experimental Spot Asset Markets

A series of experiments illustrate that relaxing short‐selling constraints lowers prices in experimental asset markets, but does not induce prices to track fundamentals. We argue that prices in experimental asset markets are influenced by restrictions on short‐selling capacity and limits on the cash available for purchases. Restrictions on short sales in the form of cash reserve requirements and quantity limits on short positions behave in a similar manner. A simulation model, based on DeLong et al. (1990) , generates average price patterns that are similar to the observed data.     

Partial Revelation of Information in Experimental Asset Markets

We develop a model of market efficiency assuming private information is partially revealed to uninformed traders via the behavior of those who are informed. This partial revelation of information (PRE) model is tested in fourteen computerized double auction laboratory markets. It explains the market value and allocation of purchased information, and asset allocations, better than either a fully revealing information model (FRE strong-form efficiency) or a nonrevealing expectations model; but it takes second place to FRE in explaining asset prices. We conjecture that refined versions of PRE may provide insight into “technical analysis” and minibubbles in securities markets.     

Circuit Breakers and Market Volatility: A Theoretical Perspective

This paper examines ex ante effects of circuit breakers (mandated trading halts). We show that circuit breakers, by causing agents to suboptimally advance trades in time, may have the perverse effect of increasing price variability and exacerbating price movements. We next consider a situation in which a circuit breaker causes trading to be halted in both a dominant (more liquid) and a satellite market. As agents switch from the dominant market to the satellite market, price variability and market liquidity decline on the dominant market and increase on the satellite market.     

Analysis of DJIA,S&P 500, S&P 400, NASDAQ 100 and Russell 2000 ETFs and their influence on price discovery

This study examines the temporal behavior of price discovery in the spot, ETF and futures markets of the DJIA, S&P 500, S&P 400, NASDAQ 100 and Russell 2000. We document an increasing trend in the price discovery metrics of exchange traded funds for all indexes but the DJIA. Contrary to past studies, our findings show that the spot market rather than the futures market leads the price discovery. The arbitrage process that links exchange traded funds to spot prices, and not the futures prices might explain the results. This daily arbitrage that ensures exchange traded funds prices equal net asset values appear to promote spot market price discovery especially with the popularity of exchange traded funds in more recent years. We additionally document that the temporal behavior of the exchange traded funds price discovery metric affects differently price discovery in the spot and futures markets across indexes.     

Risk-neutral investors do not acquire information

Give a risk-neutral investor the choice to acquire a costly signal prior to asset market equilibrium. She refuses to pay for the signal under general conditions. The reason is that a risk-neutral investor is indifferent between a risky asset or a safe bond in optimum and expects the same return to her portfolio ex ante, whether or not she acquires information. Risk neutrality thus implies the absence of costly information from asset price in competitive asset markets.     

The Dark Side of Circuit Breakers

Market-wide circuit breakers are trading halts aimed at stabilizing the market during dramatic price declines. Using an intertemporal equilibrium model, we show that a circuit breaker significantly alters market dynamics and affects investor welfare. As the market approaches the circuit breaker, price volatility rises drastically, accelerating the chance of triggering the circuit breaker—the so-called “magnet effect,” returns exhibit increasing negative skewness, and trading activity spikes up. Our empirical analysis supports the model's predictions. Circuit breakers can affect overall welfare negatively or positively, depending on the relative significance of investors' trading motives for risk sharing versus irrational speculation.     

Distilling private information from plain-vanilla options to predict future underlying stock price volatility: Evidence from the H-shares of Chinese banks

Deviations from put-call parity may arise in response to private information that a select group of investors possess. From a practical perspective, if one possesses private information, using options to speculate or hedge amplifies potential gains given the leverage embedded in options with respect to price changes in the underlying asset. In light of this, and if we assume that the average investor does not possess private information, it is perhaps possible though to infer such information through implied variance spreads and use it to predict future volatility in the underlying asset. In this piece I examine the extent to which such information is economically informative in predicting the intraday return variability of H-shares issued by China's state and joint-stock banks, respectively. Generally speaking, I uncover the following; firstly, call-put implied variance spreads are mean-reverting across time. Secondly, at any given point in time, the magnitude of the deviation from put-call parity is informative in predicting rises in future spot price volatility. Thirdly, straddle/strangle trades predict, at times one week in advance, rises in future spot price volatility. These findings hold after controlling for market-wide implied volatility, the flow and shock in information disseminating to the market, and implicit transactions costs.     

Options and efficiency: Some experimental evidence

This paper examines the information aggregation role of options when agents possess diverse information about possible asset returns. We construct two identical experimental markets: one with and one without options. We find that options speed the information aggregation process. Asset markets that have parallel option markets aggregate traders' diverse information faster than markets where options trading is not available. Implied ranges were calculated from asset and option prices and compared to the actual ranges. These comparisons suggest that options may provide a means for agents to coordinate beliefs about asset values.