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

Dissemination versus Aggregation

DisseminationThree 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.

AggregationThree 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.

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Hypotheses

Prior-Information (PI) Hypothesis (Null): Expectations are exogenous to the price formation processExpectations are formed based on prior informationInsiders have an advantage

Rational Expectation (RE) Hypothesis: Condition expectations on pricesPrices fully reveal state-of-nature Insiders do not have an advantage

Information Design

Information Design

Urn X and Urn Y: Imperfect Information in Market 1

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Dependent Variables

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Allocation

Profits

Efficiency

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

PI versus RE: Price and Allocation

Investor Type andExpected Dividend Rate

Demand and Supply SchedulesCondition on PI Expectation

Profits

PI: Profits of insiders are greater than the profits of uninformed agents

RE: Profits of insiders and the uninformed agents converge to equality

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Information Design

Information Design

Market 2

Market 3

Market 4

Market 5: Two versus Three States of Nature

Market 1: Perfect vs. Imperfect Information

PI versus RE: Allocation Distribution in All Markets

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

Profit or Wealth Distribution

Efficiency (E) and Trading Efficiency (TE)

Getting closer to RE as time progresses

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.

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