Financial Bubbles: Excess Cash, Momentum, and Incomplete Information

Abstract (Via SSRN)

We report on a large number of laboratory market experiments demonstrating that a market bubble can be reduced under the following conditions:

1) a low initial liquidity level, i.e., less total cash than value of total shares,

2) deferred dividends, and

3) a bid-ask book that is open to traders.

Conversely, a large bubble arises when the oppositeconditions exist.

The first part of the article is comprised of twenty-five experiments with varying levels of total cash endowment per share (liquidity level), payment or deferral of dividends and an open or closed bid-ask book. We find that the liquidity level has a very strong influence on the mean and maximum prices during an experiment (P <1/10,000). These results suggest that within the framework of the classical bubble experiments(dividends distributed after each period and closed book), each dollar per share of additional cash results in a maximum price that is $1 per share higher.

There is also limited statistical support for the theory that deferred dividends(which also lower the cash per share during much of the experiment) and an open book lead to a reduced bubble. The three factors taken together show a striking difference in the median magnitude of the bubble ($7.30 versus $0.22 for the maximum deviation from fundamental value).

Another set of twelve experiments features a single dividend at the end of fifteen trading periods and establishes a 0.8 correlation between price and liquidity during the early periods of the experiments. As a result, calibration of prices and evolution toward equilibrium price as a function of liquidity are possible.

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18. August 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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