1. Absence of Common Knowledge as A Source of Speculative Bubbles
Shin’ichi Hirota (Waseda University)
Shyam Sunder (Yale University)
10/12/2001

2. The purpose of our study
Explore why the price bubble occurs in stock markets
Investor’s belief on other’s belief
Stock market experiments

3. Stock market bubble in the real world
Internet Bubble
e.g. Yahoo
10$ now, $250 in the peak
Japan late 80’s
e.g. Nikkei 225 Average
10,000 yen now, 40, 000 yen in the peak
Must be bubbles
Why bubbles occur

4. Investor should expect ...
Infinitely lived investor
Discounted value of future dividends
Finite horizon investor
Resale price
Others’ valuation
Others’ expectation for the future
Future dividends
Future price

5. If he believes that …
Others will believe high future dividends or high future price,
What should he do?
Even if he does not believe high future dividends or high future price.

6. If every investor believes that
Others will believe high future dividends or high future price,
What will happen?
Even if every investor himself does not believe high future dividends or high future price

7. Stock prices are determined by
not investors’ own beliefs (first-order-beliefs)
but investors’ beliefs on others’ beliefs (second-order-beliefs)
Any Price can be observed depending on second-order-beliefs

8. Bubbles Price  Fundamental Value
Second-order-belief
Fundamental Value
First-order-belief
Second-order-belief  First-order-belief

9. Keynes Newspaper beauty contests How to verify?
Well-known and popular story
True in real world?
How to verify?
Fundamental value is unobservable
Gap is unobservable

10. Experimental Study Laboratory Experimental Results
Fundamental value is observable
Create the gap between FOB and SOB
See the effect of the gap on the stock price
Experimental Results
Bubbles occurred due to the gap
Keynes is right!

11. Experimental Markets Stock market in the laboratory
Trade a single stock
15 (12) periods of 3 minutes each
Stocks has a life during the experiment

12. How to create the gap between FOB and SOB
Each investor knows dividends (FOB)
But… SOB may be different from FOB
[Market 1]
Dividends may not be received in the investment life.
Dividends are paid only if the session lasts for 30 periods
The subjects can easily guess that the session ends earlier
The stock at the last period is evaluated at the predicted price of the next period
They have to expect what the market expects the price

13. How to create the gap between FOB and SOB (continued)
[Market 2]
15 periods. Dividends are paid at the end of Period 15.
Each knows his dividend, but does not know others’ dividends
Investors draws the dividend card
Private information
The dividend range is informed to everyone
Investors have to guess others’ dividends, i.e., others’ valuation of the stock.

14. Investrors and Predictors
Investors
10 stocks, 10,000 cash
trade stocks using caplabTM system
receive money depending on profits
Predictors
predict the next period’s price
receive money depending on the accuracy

15. Conducted Experiments what, who, where, when
2 sessions for Market 1 (Session 1, 2)
1 session for Market 2 (Session 3)
Yale university, undergraduate students
Yale School of Management, B-74 Room
September 21, 29, 30, 2001

16. Conclusion (from preliminary experimental results)
The investors’ beliefs on other’s belief (SOB) significantly affect the stock prices.
The gap between FOB and SOB seems to create bubbles in stock markets.