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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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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.






Outline

Investor Type andExpected Dividend Rate


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




Urn x and urn y imperfect information in market 1
Urn X and Urn Y: Imperfect Information in Market 1

I

I

I

Urn X

Urn Y


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



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Investor Type andExpected Dividend Rate


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Demand and Supply SchedulesCondition on PI Expectation


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


Efficiency e and trading efficiency te
Efficiency (E) and Trading Efficiency (TE)









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Market 5: Two versus Three States of Nature


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Market 1: Perfect vs. Imperfect Information


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PI versus RE: Allocation Distribution in All Markets


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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



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Efficiency (E) and Trading Efficiency (TE)

Getting closer to RE as time progresses


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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.