Seminar

Decomposing the Effects of Beliefs and Risk Attitudes during Asset Bubbles using Laboratory Data

Aj Bostian (University of Virginia)

October 11, 2010, 12:30–14:00

Toulouse

Room MF 323

Internal Finance Workshop

Abstract

Experimental stock markets containing only a single asset tend to generate bubble-crash patterns even when the fundamental value is easy to calculate (Smith et al., 1988). I present an experimental design containing one risky asset (dividend-paying stock) and one riskless asset (interest-paying cash). The stock's fundamental value is the present expected value of its future dividend stream, and this value can be made constant over time by redeeming the stock at a judiciously-chosen price at the end of trading. I present three treatments: a baseline with 20 trading periods and expected stock and cash returns of 10% per period, a "high return" treatment that increases the baseline returns to 20%, and a "long" treatment that extends the baseline duration to 40 trading periods. All three have the same fundamental value and exhibit a strong bubble-crash pattern. The average "peak boom" prices are 228%, 688%, and 1850% above fundamental in the baseline, high-return treatment, and long treatments, respectively. The baseline outcome confirms that subjects have a predilection to speculate in this new design. The high-return and long treatments both involve higher cash wealth levels, and the higher prices in these markets suggest that at least some subjects use this additional cash as fuel for further speculation. To assess the mechanics of price formation, I construct a representative-agent portfolio model in which the agent can forecast prices according to price and order-book trends in addition to fundamental information. Estimates of the model parameters with the experimental data indicate that the marginal trader is risk averse but formulates pricing beliefs primarily by extrapolating from recent market outcomes. Increased cash wealth gives the trader the ability to bid higher prices on this belief. The trader's use of historically upward-trending prices thus propagates the bubble.