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Testing Rational Expectations in Security Markets: Market Dissemination & Aggregation

Explore Plott and Sunder's experiments on insider information, market dissemination, aggregation, and rational expectations hypothesis testing. Analyze information design, cash flows, profit recording, investor types, and efficacy of market mechanisms.

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Testing Rational Expectations in Security Markets: Market Dissemination & Aggregation

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Presentation Transcript

  1. Outline • In-Class Experiment on Security Markets with Insider Information • Test of Rational Expectation Hypothesis I: Plott and Sunder (1982) • Can market be used to disseminate information? (or does price reflect insider information?) • Test of Rational Expectation Hypothesis II: Plott and Sunder (1988) • Can market be used to aggregate diverse information? (or does price reflect aggregate information?) • Field Application at HP: Kay-Yut Chen, Senior Scientist, HP Lab

  2. Dissemination versus Aggregation • Dissemination • Three states: X, Y, Z. • At the beginning of the period, the state was drawn. • If the state was X, then half of the traders were told that the state was X (insiders) and the other half did not receive any clues. • Aggregation • Three states: X, Y, Z. • At the beginning of the period, the state was drawn. • If the state was X, then half of the traders were given that the state was not Y and the other half were told that the state was not Z.

  3. Induced Preference

  4. Controls on Cash and Security Flow

  5. Trading and Cash Flow Recording

  6. Profit Recording and Cash Earning

  7. Investor Type andExpected Dividend Rate

  8. Hypotheses • Prior-Information (PI) Hypothesis (Null): • Expectations are exogenous to the price formation process • Expectations are formed based on prior information • Insiders have an advantage • Rational Expectation (RE) Hypothesis: • Condition expectations on prices • Prices fully reveal state-of-nature q • Insiders do not have an advantage

  9. Information Design

  10. Information Design

  11. Urn X and Urn Y: Imperfect Information in Market 1 I I I Urn X Urn Y

  12. Dependent Variables • Price • Allocation • Profits • Efficiency

  13. Price Determination • Expectations formed by either rational-expectation or prior information • Prices are determined by the implied demand and supply schedules in a double auction market mechanism

  14. PI versus RE: Price and Allocation

  15. Investor Type andExpected Dividend Rate

  16. Demand and Supply SchedulesCondition on PI Expectation

  17. Profits • PI: Profits of insiders are greater than the profits of uninformed agents • RE: Profits of insiders and the uninformed agents converge to equality

  18. Efficiency (E) and Trading Efficiency (TE)

  19. Efficiency (E) and Trading Efficiency (TE)

  20. PI versus RE: Price and Allocation

  21. Information Design

  22. Information Design

  23. Market 2

  24. Market 3

  25. Market 4

  26. Market 5: Two versus Three States of Nature

  27. Market 1: Perfect vs. Imperfect Information

  28. PI versus RE: Allocation Distribution in All Markets

  29. PI versus RE: Allocation Distribution in All Markets • PI and RE make different predictions in 36 out of 61 periods • In 29 out of 36 periods, error from allocations predicted by the RE model is smaller • In 18 out of 36 periods, the RE model made no errors at all. The PI model made zero errors in only 2 out of 36 periods

  30. Profit or Wealth Distribution

  31. Efficiency (E) and Trading Efficiency (TE) Getting closer to RE as time progresses

  32. Activity of Insider in the Early Rounds • In four out of 5 markets relative activity of insiders decreases with time. • It seems the competing bids and offers among insiders during the opening stages of a period, reveals the state to the uninformed.

  33. Is this a Fair Game?

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