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

Induced Preference

Controls on Cash and Security Flow

Type of Traders and Dividend Rate  Markets 1-3: Two types of trader (I and II)  Markets 4-6, 10-11: Three types of traders (I, II, and III)  Four traders in each type of traders  Markets 7-9: One type of traders but there are 12 of them  Initial endowment is 2 except in markets 5_S, 6-7, and 9- 10, it is 4

Design of Markets

Asset Type Single AssetState-Contingent Claims Uniform DividendsSeries C: 7,8,9 Diverse DividendsSeries A: 1,2,3,6,10,11 4,5-last few periods Series B: 4,5 –Periods 1-9

Single Security vs. Contingent Claims  Single Security (e.g., Market 3)  A type II trader yielded a dividend of 230 if the state was X, 90 francs if the state was Y, and 60 francs if the state was Z.  Contingent Claims (e.g., Market 4)  The contingent claims markets had 3 different securities x, y, z.  Let’s focus on Type I trader.  The x securities yielded a positive dividend of 70 if x occurred and zero otherwise.  The y securities yielded a positive dividend of 130 if y occurred and zero otherwise.  The z securities yielded a positive dividend of 300 if z occurred and zero otherwise.  A portfolio of one of each type of security is equivalent to one security in the single security markets.

Design of Markets

Hypotheses  Rational Expectation (RE) Hypothesis (Null)  Traders behave as if they are aware of the pooled information of all traders in the system. That is, they behave as if they know the state with certainty  Prior-Information (PI) Hypothesis  Determine posterior probability  EV maximizers  Maximin (MM) Hypothesis  Determine posterior probability  Traders will not purchase unless the price is below the minimum they could possibly receive given their prior information

Price and Allocation Predictions: RE vs. PI vs. MM

Design of Markets

Price and Allocation Predictions: RE vs. PI. vs. MM

PI: Prices of Contingent Claims in Market 4

Actual versus Predicted Prices at the last occurrence of each state

Market 10: RE did not work well

Market 1: RE did not work well

Market 2: RE did not work well

Market 4: RE Worked Well

Market 8: RE Worked Well

Market 9: RE Worked Well

Security Transfer Measure

Actual and Predicted Allocations at the End of Each Market

Actual and Predicted Profit Distributions

Efficiency

|Actual – Predicted Efficiency|

Summary  Behaviors in Series A (single security with diverse preferences) are only partially captured by RE model (e.g., Market 10)  If the markets are complete (as in Series B) or is preferences are identical (Series C), the RE model provides a reasonably accurate description of behaviors (Market 4-CC, Markets 8 and 9).