2003/19 LEM Working Paper Series

Expectations structure in asset pricingexperiments

Giulio Bottazzi and Giovanna Devetag
Experimental Economics, Expectations, Coordination, Asset pricing

  JEL Classifications
C91, C92, D84, G12, G14

Notwithstanding the recognized importance of traders expectations incharacterizing the observed market dynamics, for instance theformation of speculative bubbles and crashes on financial markets,little attention has been devoted so far by economists to a rigorousstudy of expectation formation in the laboratory. In this work wedescribe a laboratory experiment on the emergence and coordination ofexpectations in a pure exchange framework. We largely base our studyon previous experiments on expectation formation in a controlledlaboratory environment by Cars Hommes, Joep Sonnemans, Ian Tuinstraand Henk van de Velden (CeNDEF Working Paper, Amsterdam, 2002). Weconsider a simple two asset economy with a riskless bond and a riskystock. Each market is composed of six experimental subjects who act asfinancial advisors of myopic risk-averse utility maximizing investorsand are rewarded according to how well their forecasts perform in themarket. The participants are asked to predict not only the price ofthe risky asset at time t+1, as in Hommes et al., but also theconfidence interval of their prediction, knowing the past realizationsof the price until time t-1. The realized asset price is derived fromaWalrasian market equilibrium equation, unknown to the subjects, withfeedback from individual forecasts. Subjects earnings are proportionalto the increase in their wealth level. With respect to previousexperiments that did not include an explicit evaluation of risk byparticipants, we observe a higher price volatility, a decreasedlikelihood of bubble dynamics and, in general, a higher heterogeneityof predictions.

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