Experiments on Motives to Trade, Consumption Smoothing and Asset Price Bubbles

Description

The study of asset price bubbles is a central topic in economics. There are many examples where speculative trade in some commodity or asset generates a phase of sustained rise in price, often followed by a sudden collapse. Whether such pricing developments can be justified in terms of market fundamentals, or are they indicative of persistent deviations from intrinsic values, has been an important topic of discussion.Given that fundamental values are usually not observable, several researchers have used the methodology of laboratory experiments in order to understand the causes of systematic deviations from fundamentals and identify what features of the market or institution can help prevent such bubbles from occurring. It is now well established that although theory predicts that no trade should occur or if trade happens at all, it should take place at the fundamental value of the asset, evidence suggests that far too many trades take place and prices deviate substantially from the fundamentals. This deviation is often attributed to strategic uncertainty that arises due to investors being unsure whether other traders are rational or not.Notice that there happens to be no exogenous reason to engage in trade for the subjects participating in these experiments. If subjects have a well-defined rational need to participate in the asset market, do they trade at the fundamental values? We ask this question in our proposed research where the motive to trade is induced through consumption smoothing incentive for traders facing idiosyncratic income shocks each period. The principal goal of our study is to explore the relationship between the presence of an induced motive to trade and mis-pricing, with and without aggregate risk. At a more fundamental level, we intend to integrate the element of consumption- based general equilibrium asset pricing into experimental asset markets.We also wish to understand that if the asset is indeed priced incorrectly in the sense that the absolute level of price is too high than the fundamental value, does it prevent the ability of market participants to reduce their idiosyncratic risk via trading. That is, do “wrong” prices impede the functioning of asset market in facilitating welfare improving trades? If the answer comes out to be “no”, then the broad implication would be that one need not focus too much on the absolute level of prices but rather on the ability of the asset market to provide opportunities for Pareto-improving exchanges.