Elena Asparouhova

Inference from Streaks in Random Outcomes: Experimental Evidence on Beliefs in Regime Shifting and the Law of Small Numbers

Using data generated from laboratory experiments, we test and compare the empirical accuracy of two models that focus on judgment errors associated with processing information from random sequences. We test for regime-shifting beliefs of the type theorized in Barberis et al. (Barberis, N., A. Shleifer, R. Vishny. 1998. A model of investor sentiment. J. Financial Econom.49(3) 307--343) and for beliefs in the “law of small numbers” as modeled in Rabin (Rabin, M. 2002. Inference by believers in the law of small numbers. Quart. J. Econom.117(3) 775--816). In our experiments, we show subjects randomly generated sequences of binary outcomes and ask them to provide probability assessments of the direction of the next outcome. Inconsistent with regime-shifting beliefs, we find that subjects are not more likely to predict that the current streak will continue the longer the streak. Instead, consistent with Rabin (2002), subjects are more likely to expect a reversal following short streaks and continuation after long streaks. Results of a “test-of-fit” analysis based on structural estimation of each model also favor the model in Rabin. To provide more insight on Rabin, we use an additional experimental treatment to show that as the perception of the randomness of the outcome-generating process increases, subjects are more likely to predict reversals of current streaks.

Excess demand and equilibration in multi-security financial markets: the empirical evidence

Price dynamics are studied in a dataset of more than 11,000 transactions from large-scale financial markets experiments with multiple risky securities. The aim is to determine whether a few simple principles govern equilibration. We first ask whether price changes are driven by excess demand. The data strongly support this conjecture. Second, we investigate the presence of cross-security effects (the excess demands of other securities influence price changes of a security beyond its own excess demand). We find systematic cross-security effects, despite the fact that transactions in one market cannot be made conditional on events in other markets. Nevertheless, stability is not found to be compromised in our data. A curious relationship emerges between the signs of the cross-effects and the signs of the covariances of the payoffs of the corresponding securities. It suggests a link between price discovery in real markets and the Newton procedure in numerical computation of general equilibrium. Next, we investigate whether the book (the set of posted limit orders) plays a role in the process by which excess demand becomes reflected in transaction price changes. We find strong correlation between excess demands and a weighted average of the quotes in the book. The correlation is far from perfect, and we document that our weighted average of the quotes in the book explains part of the variance of transaction price changes that is unaccounted for by excess demands.

RANK ESTIMATORS FOR A TRANSFORMATION MODEL

We establish [square root]n-consistency and asymptotic normality of Hans (1987a, Journal of Econometrics 35, 191–209) estimator of the parameters characterizing the transformation function in a semiparametric transformation model. We verify a Vapnik–Cervonenkis (VC) condition for the parameterizations of Box and Cox (1964, Journal of the Royal Statistical Society, Series B 34, 187–200) and Bickel and Doksum (1981, Journal of the American Statistical Association 76, 296–311). The verification establishes the VC property for a class of sets generated by a nonlinear function of the transformation parameters. We also introduce a new class of rank estimators for these parameters. These estimators require only O(n2 logn) computations to evaluate the criterion function, compared to O(n4) computations for Hans estimator. We prove that these estimators are also [square root]n-consistent and asymptotically normal. A simulation study compares two of the new estimators to Hans estimator, the fully parametric estimator of Bickel and Doksum (1981), and the nonlinear two-stage least squares estimator of Amemiya and Powell (1981, Journal of Econometrics 17, 351–381).

Asset Pricing and Asymmetric Reasoning

We test to what extent financial markets trigger comparative ignorance (Fox and Tversky (1995)) when interpreting news, and hence, to what extent such markets instill ambiguity aversion in participants who do not know how to correctly update. Our experiments build on variations of the Monty Hall problem, which, when tested on individuals separately, are well known to generate obstinacy: subjects often refuse to acknowledge that they are wrong. Under comparative ignorance, however, subjects who are not able to correctly solve Month-Hall-like problems should become ambiguity averse. In a financial markets context, we posit that such feeling of comparative ignorance emerges when traders, who do not have the correct solution, face prices that contradict their beliefs. Previous experiments with financial markets have shown that ambiguity aversion makes subjects hold portfolios that are insensitive to prices; subjects instead prefer to hold balanced portfolios, and hence, are not exposed to ambiguity. And because subjects are price-insensitive, they do not contribute to price setting. This led us to hypothesize that, when faced with MontyHall-like problems, (i) there would be subjects whose portfolio decisions are insensitive to prices, (ii) price quality would be inversely related to the proportion of price-insensitive subjects, (iii) price-insensitive subjects tend to choose more balanced portfolios (correcting for mispricing), and (iv) price-insensitive subjects trade less. Our experiments confirm these hypotheses. We do discover, however, the presence of a minority of price-sensitive subjects who simply tend to buy more as prices increase. We interpret the behavior of such subjects as herding, a hitherto unsuspected reaction to comparative ignorance. Altogether, our experiments suggest that cognitive biases may be expressed dierently in a financialWe present a new theory of asset pricing and portfolio choices under asymmetric reasoning, contrast the predictions with those under asymmetric information, and present experimental evidence in favor of our theory. The Efficient Markets Hypothesis and its formal foundation, the Rational Expectations Equilibrium, predict that asymmetric information is irrelevant because prices correctly aggregate all available information. We argue here that asymmetric reasoning is fundamentally different: prices may not reflect all (types of) reasoning because (some) agents who observe prices that cannot be reconciled with their reasoning drop their reasoning while not giving prices the benefit of the doubt, and hence become sufficiently ambiguity averse so that they no longer directly influence prices. We present the results from an experiment, where, through manipulation of aggregate risk, we separately test the price and choice implications of our theory. Consistent with our theory, we find that i) a significant fraction of our subjects become price-insensitive, that ii) mispricing decreases as the fraction of price-sensitive agents increases when there is no aggregate risk, and iii) price-insensitive agents tend to trade to more balanced portfolios when there is aggregate risk.

Competition in Portfolio Management: Theory and Experiment

We explore theoretically and experimentally the general equilibrium price and allocation implications of delegated portfolio management when the investor--manager relationship is nonexclusive. Our theory predicts that competition forces managers to promise portfolios that mimic Arrow--Debreu AD securities, which investors then combine to fit their preferences. A weak version of the capital asset pricing model CAPM obtains, where state prices relative to state probabilities implicit in prices of traded securities will be inversely ranked to aggregate wealth across states. Our experiment broadly corroborates the price and choice predictions of the theory. However, price quality deteriorates when only a few managers attract most of the available wealth. Wealth concentration increases because funds flow toward managers who offer portfolios closer to replicating AD securities as in the theory, but also because funds flow to managers who had better performance in the immediate past an observation unrelated to the theory. This paper was accepted by Jerome Detemple, finance.

Experiments on Percolation of Information in Dark Markets

In dark markets, order submissions are bilateral, and transaction prices are known only to the trading counterparties. Here, we study to what extent the information aggregation theory proposed by Duffie and collaborators predicts outcomes in a laboratory version of such markets. We find that prices aggregate the available information but not in the strict sense of the theory, where prices converge exponentially fast to average private signals. Prices instead fluctuate within bands around this average. The band widths reflect, in the best case, the precision of the average signal and, otherwise, the precision of a single private signal.

Competitive Off-Equilibrium: Theory and Experiment

We propose a Marshallian model for price and quantity adjustment in parallel continuous double auctions. Investors submit orders only for small quantities, and at prices that maximize the local utility improvements. Pareto optimality, on which equilibrium asset pricing theory is built, is eventually reached. Experiments designed with the CAPM in mind show that, consistent with the theory (i) contrary to the standard Walrasian price adjustment model, price changes cross-auto correlate with excess demands depending on covariances of liquidating dividends; (ii) a risk-weighted endowment portfolio is closer to mean-variance optimality than the market portfolio; (iii) individual portfolios are under-diversified, and more so when dividend covariances are positive.

Costly Information Acquisition in Decentralized Markets: An Experiment

This study tests the rationality of the decisions to purchase information, the informational efficiency of prices, and the optimality of the resulting allocations with a series of laboratory experiments in decentralized markets. The theory predicts that markets with dispersed information and natural buyers and sellers converge to a fully revealing equilibrium. It is profitable to pay for information and as such, the Grossman-Stiglitz paradox does not emerge. Statistically significant improvements in both price efficiency and allocative efficiency are documented across trading periods. In contrast with centralized markets, participants in decentralized markets remain willing to pay for information in all replications.