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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?)

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Presentation Transcript
outline
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
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.
hypotheses
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
dependent variables
Dependent Variables
  • Price
  • Allocation
  • Profits
  • Efficiency
price determination
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
profits
Profits
  • PI: Profits of insiders are greater than the profits of uninformed agents
  • RE: Profits of insiders and the uninformed agents converge to equality
slide29

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
slide31

Efficiency (E) and Trading Efficiency (TE)

Getting closer to RE as time progresses

slide32

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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