Download Lei, Noussair, and Plott: Non-Speculative Bubbles in Experimental

Lei, Noussair, and Plott: Non-Speculative Bubbles in
Experimental Asset Markets: Lack of Common
Knowledge of Rationality vs. Actual Irrationality
Economics 328
Spring 2005
Prices from Tuesday’s Experiment
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Price
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Round 1 Round 2 Round 3 Round 4 Round 5 Round 6 Round 7 Round 8 Round 9 Round
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Average Price
Expected Value
Round
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Round
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Round
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An Introduction to Bubbles
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The experiment we ran in class on Tuesday closely resembles many previous
experiments run by researchers. A single DOA market is run for a known finite
number of rounds. Traders are allowed to buy and sell, raising the possibility
of speculation. The asset being sold is typically a risky security that pays a
dividend in each round. If individuals are risk neutral, the price should be
linearly decreasing over time. If individuals are risk adverse, prices should be
bounded above by the expected value line.
Ex ante, most economists would expect to see little trading in a market like
this. However, in fact we typically see frenzied trading. Economists also
would expect to see prices at or below the expected value. In fact, we often
observe large bubbles – persistent pricing of the security above its
fundamental value.
It has been argued that such bubbles are also a feature of real world security
markets. It is hoped that if we can understand how bubbles form in the
laboratory, we can also understand how they form (and can be prevented) in
real world financial markets.
Tulipmania (Holland, 1634 – 1637)
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There have been a number of dramatic
examples of bubbles observed in
financial markets, often with dire
consequences.
Speculation in "bizarres," tulip bulbs
infected with the mosaic virus, runs
rampant, fueled in part by use of call
options to leverage investments. In
January of 1637, prices of bulbs increase
by more than 1000%. The price of one
special, rare type of tulip bulb called
Semper Augustus was 1000 guilders in
1623, 1200 guilders in 1624, 2000
guilders in 1625, and 5500 guilders in
1637 (equal to about $50,000). Another
bulb was sold in February 1637 for 6700
guilders. Prices collapsed in February,
setting off a prolonged depression.
The South Sea Bubble (England, 1720)
•
The South Sea Company was formed in 1711. Given a monopoly over trade with South
America in exchange for taking on some government debt, the company was never
profitable. Peace with Spain in 1719 and an ongoing stock bubble on the continent
spurred interest in the South Sea Company. In January of 1720, the stock price stood at
slightly more than £125/share. New stock was issued at £300/share in April of 1720.
Spurred by speculative interest and easy credit, prices soon soared over £1000/share.
The stock price collapsed in fall of 1720, spurred by a liquidity crisis caused by passage of
the Bubble Act and sale of shares by the firm's directors.
Black Tuesday (U.S., 1928 – 1929)
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The 1920s were a period of strong economic growth, spurred in part by changes in
production technology. For a variety of reasons, interest in stocks grew in this period as
well. In March 1928, stock prices began a sharp upwards climb. While originally based on
good economic news, this rapid increase was spurred on by the presence of speculators
and easy credit. Stock prices had almost doubled by the summer of 1929. In late summer
and early fall of 1929, signs began to accumulate of an oncoming recession. As stock
prices began to drift lower, investors began to face margin calls. Unable to meet these
margin calls, they were forced to liquidate their holdings. The stock market's fall
snowballed, culminating in Black Thursday (October 24, 1929) and Black Tuesday
(October 29, 1929) when the markets were in free fall. Stock prices eventually fell by over
50% from their high point. While the 1929 crash was probably not the cause of the Great
Depression, it was certainly a harbinger.
Another Historical Bubble?
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Prices for tech stocks in the U.S. markets (largely NASDAQ), became hugely
overvalued in the late 1990s. Stock for firms that had never shown any profit
and showed little prospect for future profits sold at the sorts of prices usually
reserved for blue chip stocks. Eventually, the financial law of gravity kicked in
and prices crashed. The long term implications of this bubble are still not
clear.
Bubbles in the Lab
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Economists have run a number of
experiments exploring this
phenomenon. Generally, it isn’t
hard to produce bubbles in the lab.
Smith, Suchanek, and Williams
(1988) ran 28 sessions of 15 rounds
using a DOA design with a risky
asset like we’ve used in class.
They find that prices typically start
well below expected value, bubble
up in the middle rounds, and then
collapse at the end of the
experiment. This has been
replicated many times, although
there have been exceptions
(Camerer and Weigelt, 1990).
Bubbles in the Lab
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Changes in institutions that might be expected to eliminate bubbles do not
appear to have the expected effect. King, Smith, Williams, and Van
Boening (1993) allow for short selling, buying on margin, brokerage fees,
and limits on price changes (circuit breakers). None of these institutional
changes has much impact on the formation of bubbles. Porter and Smith
(1995) find that neither allowing a futures market nor eliminating dividend
uncertainty eliminates bubbles. Van Boening (1993) used sealed bid
auctions and still observed bubbles. Fisher and Kelly (1998) have two
markets operating simultaneously, and still observe bubbles forming and
crashing.
Experience has some impact. Subjects who have previous experience
with bubble experiments produce fewer (and smaller) bubbles (King et al,
1993; Peterson, 1991). However, sessions with business professionals are
just as likely to produce bubbles (Smith et al, 1988; King et al, 1991).
Lei, Noussair, and Plott – Research Question
• Two possible explanations for the occurrence of bubbles are
the “speculative hypothesis” and the “active participation
hypothesis.” In the first, traders are hoping to take advantage
of irrational individuals or other speculators to make a large
profit through capital gains. In other words, they are market
timing. As the end of the market approaches, the bubble
inevitably collapses. (This hypothesis does not require the
presence of irrational traders to generate a bubble. All that is
needed is a failure of common knowledge of rationality. Think
about the relationship between this and Nagel’s guessing
game that we studied earlier this semester.) The second
hypothesis focuses on the methodology. In most bubble
experiments, the only activity available to subjects is trading.
To the extent that the protocols encourage participation,
subjects make unprofitable trades just to be doing something.
In other words, bubbles are a subtle type of demand induced
effect. Lei et al aim to test these two hypotheses, separately
and in conjunction.
Experimental Design and Procedures
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Experiments were conducted using a standard continuous double oral auction
program. A total of 16 sessions were run. Each session had between 12 and
18 periods, with the number of periods pre-determined and known by the
subjects. There were four main treatments:
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No-Spec: This treatment was designed to eliminate speculation as a possible cause
for bubbles. Subjects were assigned a role as a buyer or a seller and were not
allowed to resell units, eliminating any possibility of capital gains. (3 sessions)
Two-Market: A second market was added to the design. This market was for a nondurable good (service) that only lasted for one period. Subjects were assigned a role
as a buyer or a seller in this market and supply and demand curves were induced in
the standard fashion. This second market gives subjects something to do other than
participate in the risky asset market. (6 sessions)
Two-Market/No Spec: This was the natural combination of the preceding two
treatments – subjects in the risky asset market could no longer resell assets. (3
sessions)
One-Market: These were control sessions analogous to a standard bubble
experiment. (4 sessions)
Results
• Substantial bubbles are
observed in the no-spec
treatment, indicating that
speculators are not needed
for bubbles to form. The
presence of sales that could
not possibly be profitable
(buying above the maximum
possible dividend payoff or
selling below the minimum
possible dividend payoff) as
well as excess volume
indicate systematic errors in
decision making.
Results
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The volume of trading is significantly reduced in the two-market treatment. The volume of
trades falls by about 35% when a second market is introduced. However, bubbles are still
observed and median prices are not significantly affected by the introduction of a second
market. Thus, the data supports the Active Participation Hypotheses, but this hypothesis
cannot explain the pricing patterns in bubbles.
Results
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The two-market/no-spec treatment
brings the results even closer the
“rational” outcome. There are fewer
dominated trades and the excess volume
is cut even more. However, one of the
three sessions still shows a bubble. The
authors speculate that bubbles will be
less frequent in the two-market/no-spec
treatment, but there aren’t enough
sessions to test this hypothesis.
In the two market experiments, the
departure of prices from fundamentals
observed in the assets markets does not
extend to the service markets. In the
service markets, prices converge to the
competitive equilibrium. This suggests
that any irrationality being observed in
these experiments cannot be attributed
solely to the subjects, but must instead
rely on an interaction between the
subjects and the asset markets
Conclusions
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The experimental results indicate that speculation is not necessary to
create bubbles. This doesn’t mean that speculation can’t occur in
bubbles, but instead that bubbles could still occur even without
speculators. Models of “rational” bubbles which rely on a failure of
common knowledge of rationality receive little support here – at least
some subjects are clearly making errors that are inconsistent with
rationality.
The standard methodology used in bubble experiments drives some
of the apparently irrational behavior – particularly the high volume of
trading and the prevalence of dominated trades. However, the most
striking feature of bubbles, the boom and then crash in prices, is not
eliminated by using a methodology that gives subjects an option
other than trading in the asset market.
The authors speculate that bubbles are driven by an interaction
between naïve traders and speculators. This raises some intriguing
possibilities for how bubbles occur in real financial markets. One
interesting feature of the U.S. stock markets in the late 1990’s is how
broad participation. It may be this influx of novice investors that
created the conditions for the apparent stock market bubble observed
in NASDAQ.
Additional Studies
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Haruvy and Noussair (2003) reexamine the effect of short selling on
the occurrence of bubbles. Their primary innovation is to
substantially increase subjects’ short selling capacity beyond that
allowed in earlier experiments. Short selling significantly depresses
asset prices, but does not induce prices to track fundamentals.
Noussair and Tucker (2003) study bubbles in the presence of multiple
futures markets. The presence of these futures markets induces
prices to follow fundamentals, presumably by inducing greater
backward induction. This is an intriguing result although the
structure of the futures markets is quite stylized.
Dufwenberg, Lindqvist, and Moore (2003) study markets in which
experienced and inexperienced traders are mixed. They find that
even a fairly small proportion of experienced traders (1/3 of the
population) is sufficient to largely extinguish the occurrence of
bubbles. This provides some explanation for why bubbles are rare
occurrences.