Asymmetric Information and Bubbles: An Experiment

Michael Brandner

Jürgen Huber

Michael Kirchler

Matthias Sutter

all University of Innsbruck

Asymmetric Information and Bubbles Michael Brandner et al.

Outline

Introduction

Model description

Experimental implementation

Hypotheses

Results and interpretation

Concluding remarks

Asymmetric Information and Bubbles Michael Brandner et al.

Introduction

Starting point is the well-known basic setup of Smith, Suchanek and Williams (1988) – subsequently SSW

Outstanding characteristic: declining fundamental value in the course of a market

Typically, bubbles can be observed in this setting

Related literature, revealing determinants for bubble reduction:

Less frequent dividend payments (Smith et al. 2000) Constant fundamental value (Noussair et al. 2001) Detailed instructions (Lei et al. 2001) Futures markets (Noussair and Tucker 2004) Experience (Dufwenberg et al. 2005) Short selling (Haruvy and Noussair 2006)

Asymmetric Information and Bubbles Michael Brandner et al.

Model description

Basic features:

Assets of a virtual enterprise are traded - after every trading period the stock pays a dividend amounting to either zero or 20 MU (given equal probability)

All traders know the dividend generating process, but nobody exhibits information about the actual dividend realizations before a period’s termination

No “buy-out” option is introduced so that assets are worthless after a round’s termination (one round being 10 successive periods), implying declining fundamental values

Asymmetric Information and Bubbles Michael Brandner et al.

Model description

We test for the impact of different information structures on bubble formation – public information and asymmetric information

Reference treatment (T1): symmetric (non-) information about future dividends (comparable e.g. to SSW (1988), Dufwenberg et. al (2005)) – all traders are of type I0 (just knowing the dividend generating process)

Public information (T2): each trader is informed about the dividend realization of the current period from the outset – all traders are type I1

Asymmetric information (T3): on average, traders also know one future dividend, but this information is asymmetrically distributed – two traders are of type I0, two of I1, and two are allocated to type I2 (so-called insiders, knowing the current and next period’s dividend realizations)

Asymmetric Information and Bubbles Michael Brandner et al.

Experimental implementation

One market is populated by six traders - distribution of information levels in the three treatments:

We replicate three rounds in a market – one round consisting of 10 periods (lasting for 120 seconds each)

Initial endowments: 3,000 MU and 10 assets/1,000 MU and 30 assets (expected final profit is equal)

Money and asset holdings are carried over from period to period, but reset to the respective starting levels after a round’s termination (no “buy-out” option, assets‘ life-span is ten periods)

Asymmetric Information and Bubbles Michael Brandner et al.

Experimental implementation

The market is a continuous double auction with open order book, implemented with z-Tree (Fischbacher, 2007)

Subjects can trade any quantity of assets, given the limitations of their asset inventory and cash endowment (neither loans are provided nor is short selling allowed)

We conduct six markets per treatment for a total of 18 markets (at the University of Innsbruck)

Participants have been business students with no previous experience in similar experiments

Asymmetric Information and Bubbles Michael Brandner et al.

Trading screenInformation about future dividend(s)

Asymmetric Information and Bubbles Michael Brandner et al.

History screen

Asymmetric Information and Bubbles Michael Brandner et al.

Hypotheses

H1: Public information (T2) about current period‘s dividend decreases bubble-size (compared to T1)

H2: Asymmetric information (T3) about future dividends decreases bubble-size (compared to T1)

H3: Informed traders will use the fundamental information provided so that prices increase when they see high dividends and fall when they see low dividends

H4: Subjects in T3 have an increased incentive to trade across information levels

Asymmetric Information and Bubbles Michael Brandner et al.

Results

Mean Prices (weighted)

0

20

40

60

80

100

120

0 5 10 15 20 25 30

Period

Me

an

Pri

ce

Fundamental T1 (I0)

Asymmetric Information and Bubbles Michael Brandner et al.

Results

Mean Prices (weighted)

0

20

40

60

80

100

120

0 5 10 15 20 25 30

Period

Me

an

Pri

ce

Fundamental T1 (I0) T2 (I1)

Asymmetric Information and Bubbles Michael Brandner et al.

Results

Mean Prices (weighted)

0

20

40

60

80

100

120

0 5 10 15 20 25 30

Period

Me

an

Pri

ce

Fundamental T1 (I0) T3 (I0 - I2)

Asymmetric Information and Bubbles Michael Brandner et al.

Results

Mean Prices (weighted)

0

20

40

60

80

100

120

0 5 10 15 20 25 30

Period

Me

an

Pri

ce

Fundamental T1 (I0) T2 (I1) T3 (I0 - I2)

Asymmetric Information and Bubbles Michael Brandner et al.

Results

Mean Prices (weighted)

0

20

40

60

80

100

120

0 5 10 15 20 25 30

Period

Me

an

Pri

ce

Fundamental T1 (I0) T2 (I1) T3 (I0 - I2)

Average price departures:

T1: 40.6 MU

T2: 25.3 MU

T3: 18.4 MU

Asymmetric Information and Bubbles Michael Brandner et al.

Results – impact on bubble-size

Comparing bubbles (overvaluation = trading price minus corresponding fundamental value) in the three treatments pairwise (two-sided Mann-Whitney U-tests):

H1 and H2 cannot be rejected: bubbles are significantly smaller in markets with knowledge about the current dividend (T2 – public information), and smaller again when dividend information is asymmetrically distributed (T3)

Asymmetric Information and Bubbles Michael Brandner et al.

Explaining bubble-size reduction in T2 and T3

H3: Informed traders will use the fundamental information provided so that prices increase when they see high dividends and fall when they see low dividends

We examine the relationship between known positive/negative dividend realizations and the extent of overvaluation (trading price minus the corresponding fundamental value) – correlation implies prices closer to fundamentals

H3 cannot be rejected: informed trader obviously concentrate more on the fundamentals of the stock (than on the hope for capital gains) with the consequence that prices track fundamentals closer

Asymmetric Information and Bubbles Michael Brandner et al.

Trade activities within and across information levels in T3

H4: Subjects in T3 have an increased incentive to trade across information levels

If subjects in T3 do indeed base their trading decision on their given dividend information, traders within any given information level should be rather homogeneous in their trading decisions

The following matrix reveals pro-rata transactions, measured by the total amount of accomplished trades in T3 (n=1334)

I0 I1 I2

I0 4.1 % 22.6 % 30.3 %

I1 - 6.3 % 27.7 %

I2 - - 9.0 %

Asymmetric Information and Bubbles Michael Brandner et al.

Trade activities within and across information levels in T3

Trading frequency is significantly lower between information levels than across

A possible explanation is that traders within each information level form similar beliefs based on the information they get and trade on these beliefs

H4 cannot be rejected: additional support that traders in T3 increasingly focus on fundamentals (thus implying that prices track fundamentals closer)

Asymmetric Information and Bubbles Michael Brandner et al.

Concluding remarks

Both changes to the standard setup – public and asymmetric information – reduce bubbles significantly (more pronounced effect in the latter treatment)

Informed subjects in T2 and T3 base trading decisions on the information they receive, thus prices track fundamentals closer, making speculation less likely to occur

Implication: Real financial markets are undoubtedly characterized by mixed-experienced traders (recall Dufwenberg et. al (2005)) with asymmetric information about future cash flows, so that it should not be surprising that bubbles are indeed rare. The spectacular ones are less than five in a century (e.g. 1929, 1987 and the late 1990ies)!

Asymmetric Information and Bubbles Michael Brandner et al.

Thank you for your attention!