The Blind Leading The Blind, by Flemish painter Pieter Breughel Sr.
The Blind Leading The Blind, by Flemish painter Pieter Breughel Sr.
One of the earliest results in experimental finance was to demonstrate, consistent with theory, that markets (organized as continuous double auctions!) could aggregate information. Even better: prices not only reflected the average information out there, but did better than the average. Somehow, the uninformed (the blind) were able to extract information from order and trade flow despite the fact that they could not identify where the orders or trades came from. They then used the extracted information to improve their own orders and trades, thereby amplifying the insider information. This finding goes back to work by Charles Plott and Shyam Sunder in the 80s. We have been able to replicate it many times in our laboratory experiments...
We have also fine-tuned the experiment, by bringing its design closer to the theory. Specifically, the theory requires that there be a reason to trade besides information differences. We set up our markets in such a way that traders would want to engage in exchange even if there were no asymmetric information. Also, to ensure that we can interpret prices correctly, we design our experiments so that there is no aggregate risk, and hence, in theory prices would reflect risk neutrality (and hence equal expected payoffs) even in the face of risk sensitivity among traders. Our novel design avoids some of the anomalies observed in earlier experiments, such as markets betting on the wrong information ("information mirages").
It is remarkable how good people are at extracting information from order and trade flow. Remember that in most cases, our subjects are not professional traders. Yet they quickly manage to interpret patterns in the data and trade accordingly. We wondered about this, and since we had no theory to go by, we decided to put subjects in the "scanner" while we replayed some of our markets. In a blatant mis-use of functional Magnetic Resonance Imaging methodology, we reverse-inferred how our subjects were thinking: to our surprise, we found that subjects were actually not engaging brain regions usually associated with mathematical reasoning – they were not trying to "think through" the problem the way an economist would – but instead solely engaged regions usually involved in social cognition, in particular, those regions that have been demonstrated to be crucial in deciphering other people's intentions, i.e., "Theory of Mind." Armed with a hypothesis that we "stole" from the brain images, we set out to test whether indeed subjects with better "Theory of Mind" were also better at predicting prices in markets with insiders (while those with better math skills would be no better). We confirmed this... The results have been published in the Journal of Finance.
We continue to explore markets with insiders (traders that are better informed). We have been interested in price dynamics: how do markets move towards the equilibria of the theory where all or part of insider information is revealed? We borrow from market microstructure theory to interpret the data. And we are interested in identifying patterns in the data that allow uniformed to (i) detect that there are informed traders, (ii) infer the information of the insiders. Here, we have been observing that heteroskedasticity (time-varying volatility) in the price series is crucial.