Efficiency of Experimental Security Markets with Insider Information: An Application of Rational-Expectations Models

Abstract

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. The study reports on the ability of competing models of market information integration and dissemination to explain the behavior of simple laboratory markets for a one-period security. Returns to the security depended upon a randomly drawn state of nature. Some agents (insiders), whose identity was unknown to other agents, knew the state before the markets opened. With replication of market conditions the predictions of a fully revealing rational-expectations model are relatively accurate. Prices adjusted immediately to near rational-expectations prices; profits of insiders were virtually indistinguishable from noninsiders; and efficiency levels converged to near 100 percent.

Price-conveyed Information versus Observed Insider Behavior: A Note on Rational Expectations Convergence

“…This structure was designed to limit the ability of uninformed traders to infer the identities of the informed traders, since in each period different combinations of traders were informed. Such a replication, with equivalent empirical results, would provide strong evidence to support the conjecture that holding the informed traders constant did not generate the results reported in Plott and Sunder (1982) and Friedman, Harrison, and Salmon (1984).…”

“…Each type consisted of four traders, for a total of 12. The parameters, as shown in table 1, were chosen to conform to those of Plott and Sunder ( 1982), with the exception that the probability of any state occurring was simplified to one-third for each state. Each trader had a number of information and record sheets, one for each period, which consisted of possible valuations (one per state), initial endowments (held constant for all traders and for all periods at two securities and 10,000 francs), and room to keep running totals of securities and currency.…”

“…In the singlecommodity markets, Plott and Sunder ( 1983) concluded that the RE model did not perform as well as the PI model in their respective predictions. Thus, given the fixed-information structure of Plott and Sunder (1982) and Friedman, Harrison, and Salmon (1984), one cannot ignore the possibility that, in these experiments, initially uninformed traders guessed the identities of the informed traders and then used their observed behavior to gain knowledge of the state, as opposed to gaining knowledge from the market bids, offers, and pnces.…”

“…The experiment consisted of replicating experiment 5 of Plott and Sunder ( 1982), altering only the information structure so that each trader was informed of the state in at least 2 periods (out of a possible 10) and then randomizing over which periods a trader was informed. This structure was designed to limit the ability of uninformed traders to infer the identities of the informed traders, since in each period different combinations of traders were informed.…”

The effect of rating agencies on herd behaviour

“…Experimental economics literature suggests that the market may act as a sort of disciplining device on 'irrational' behaviour in individual contexts (Smith, 1962;Plott and Sunder ,1982). Hey and Morone (2004) emended a simple model of informational cascades in a market contest.…”