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

Induced Preference

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Markets 1-3: Two types of trader (I and II)

Markets 4-6, 10-11: Three types of traders (I, II, and III)

Four traders in each type of traders

Markets 7-9: One type of traders but there are 12 of them

Initial endowment is 2 except in markets 5_S, 6-7, and 9-10, it is 4

Design of Markets

Asset Type

Single Asset State-Contingent Claims

Uniform Dividends Series C: 7,8,9

Diverse Dividends Series A: 1,2,3,6,10,11

4,5-last few periods

Series B:

4,5 –Periods 1-9

Single Security vs. Contingent Claims

Single Security (e.g., Market 3) A type II trader yielded a dividend of 230 if the state was X, 90 francs if the

state was Y, and 60 francs if the state was Z.

Contingent Claims (e.g., Market 4) The contingent claims markets had 3 different securities x, y, z. Let’s focus on Type I trader. The x securities yielded a positive dividend of 70 if x occurred and zero

otherwise. The y securities yielded a positive dividend of 130 if y occurred and zero

otherwise. The z securities yielded a positive dividend of 300 if z occurred and zero

otherwise. A portfolio of one of each type of security is equivalent to one security in the

single security markets.

Design of Markets

HypothesesRational Expectation (RE) Hypothesis (Null)

Traders behave as if they are aware of the pooled information of all traders in the system. That is, they behave as if they know the state with certainty

Prior-Information (PI) HypothesisDetermine posterior probability EV maximizers

Maximin (MM) HypothesisDetermine posterior probabilityTraders will not purchase unless the price is below the

minimum they could possibly receive given their prior information

Price and Allocation Predictions:RE vs. PI vs. MM

Design of Markets

Price and Allocation Predictions:RE vs. PI. vs. MM

PI: Prices of Contingent Claims in Market 4

True State is X Clues GivenNot Y Not Z

Price of Securityx-certificate 101 146 Trader Type II IIy-certificate 0 58 Trader Type III IIIz-certificate 169 0 Trader Type I I

Actual versus Predicted Prices at the last occurrence of each state

Market 10: RE did not work well

Market 1: RE did not work well

Market 2: RE did not work well

Market 4: RE Worked Well

Market 8: RE Worked Well

Market 9: RE Worked Well

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Actual and Predicted Allocations at the End of Each Market

Actual and Predicted Profit Distributions

Efficiency

Efficiency

|Actual – Predicted Efficiency|

SummaryBehaviors in Series A (single security with

diverse preferences) are only partially captured by RE model (e.g., Market 10)

If the markets are complete (as in Series B) or is preferences are identical (Series C), the RE model provides a reasonably accurate description of behaviors (Market 4-CC, Markets 8 and 9).