Experimental Economics Fall 2009 Yale University

 How does bankruptcy protection affect a double auction securities market?  Examining price, leverage, number of transactions, and market efficiency

 We began exploring the concepts of debt and borrowing in economies  Leverage in financial markets has been called one of the main factors contributing to the recent financial crisis  Most of the large participants in securities markets use leverage (hedge funds, investment banks, trading shops)  We wanted to explore how different downside risk scenarios affect leverage in the market as well as the price and efficiency of the market itself

 We predicted that the presence of bankruptcy protection would incentivize buyers in the market to borrow more and the market would reach an equilibrium price higher than that of the market without bankruptcy protection  Without bankruptcy protection, we expected market participants to behave more conservatively and risk conscious

 Double auction securities market  Designated buyers and sellers  14 Buyers endowed with 0 assets and 150 cash  7 Sellers endowed with 6 assets and 0 cash  Two periods of trading in each round  Participant could borrow up to 3x initial cash balance  Coin toss at end of each period to determine high or low security payout  Seller payout was 150 high / 100 low  Buyer payout was 300 high / 100 low

 Transaction Volume

 Market Efficiency

 Leverage

 Asset Price: We expected a price between 125 and 200. No noticeable bankruptcy specific pattern. Perhaps our mistake in keeping prices constant.  Market Efficiency: In the rounds with bankruptcy protection, the market was more efficient by approximately 10-15%  Number of Transactions: There were significantly more transactions in rounds with bankruptcy protection  Leverage: In the rounds with bankruptcy protection average leverage was 1.1 and 0.7, and in rounds without average leverage was 0.7 and 0.4

 While leverage is often criticized and blamed for instability in securities markets, there seem to be advantages in market efficiency and overall transaction volume

 Is there a link between asset prices and leverage ratios in the market?  Should the government regulate individual’s leverage ratios?  Is there a more efficient structuring for bankruptcy protection?