This laboratory is dedicated to the study of financial markets. Its goal is to understand the basic principles, if there are any, behind the pricing, trading and information aggregation in financial markets.
There is certainly no lack of theory, but there is little conclusive empirical evidence that the theory makes sense. Perhaps the only part of the theory that receives most empirical support is that financial markets are hardly predictable. Other than this, the theory looks more like an elegant mathematical justification for the confidence that people have in financial markets, rather than a set of principles solidly based on scientific research and capable of predicting future outcomes.
The bulk of the empirical evidence to date has come from historical analysis of organized stock, bond, futures and options markets. Verification of theory on the basis of historical data is challenging and requires sophisticated statistics. (Imagine being asked to verify on a history of naturally falling objects that the acceleration caused by gravity is a constant 9.8 m/s2!) The evidence has been rather discouraging, to the extent that some have resorted to purely statistical, "black box" modeling of financial markets.
The Caltech Laboratory For Experimental Finance (CLEF) takes a different approach. It designs its own, tighly parametrized financial markets, and studies their workings. In them, real people trade for real money. The purpose is to understand to what extent theory makes valid predictions about pricing, trading and information aggregation, and, to the extent that this fails, to develop better theory. There is no pretense of emulating naturally occurring markets such as the New York Stock Exchange. Instead, the goal is to discover whether there are any basic principles behind the workings of financial markets, and if so, what these are. Sort of doing what physicists started doing four centuries ago.
The analogy with physics is not far-fetched. Asset pricing theory makes predictions about an extreme form of markets, namely, the perfectly competitive ones, where participants cannot single-handedly influence prices. They are like the vacuum in physics: irrealistic, but hopefully useful to understand the real world. At CLEF, we try to design markets that emulate the characteristics of competitive markets – a task that turns out to be far more challenging than creating something that works like a vacuum. In these artificial competitive markets, we study to what extent extant theory makes valid predictions and we attempt to discover new principles on which theory can be extended.
Asset pricing theory imputes aggregate phenomena to behavior of market participants. In field markets, individual behavior is almost never observed. Laboratory markets, in contrast, provide a unique opportunity to observe individual behavior and to determine whether it links with market-wide phenomena as assumed in the theory.
In order to better understand the origins of individual behavior in financial markets, CLEF has recently joined efforts with a number of social- and neuro-scientists at Caltech to explore the physiological foundations of financial decision making. Among other things, this involves functional magnetic resonance imaging (fMRI). So far, simple one-person decision tasks have been studied. At a later stage, individual decision making in a financial markets context is to be analyzed.
CLEF is mainly a cyberspace laboratory. Our experimental financial markets operate over the internet. Subjects participate remotely, obviating the need for a physical laboratory filled with computer terminals. CLEF is essentially a collection of powerful servers, the people who develop the software and operate the servers, the people who recruit and pay market participants ("subjects"), the people who analyze the results, and, of course, the people who design the markets in the first place.
The main asset of CLEF is its markets software, called jMarkets. It allows us to run large-scale financial markets experiments reliably and flexibly over the web. jMarkets is pure-Java and J2EE compliant. It was developed from the beginning to become open-source, and the release of version 1.0 to the academic community is planned for 15 March 2005. We decided to make jMarkets open source, in order to promote experimental research on financial markets. Our research to date has demonstrated the potential of experiments, paving the way to investigating longstanding questions. But many more exciting questions exist than we can address on our own. jMarkets' features will make it accessible to other research groups, usable in a variety of locations and populations. It is to become a tool to which many research groups will have easy access and to which they will be able to contribute. Click on the link jMarkets to the left for more information.
CLEF uses its own servers, as well as the servers and facilitaties of Caltech's Social Science Experimental Laboratory (SSEL) and UCLA's California Social Science Experimental Laboratory (CASSEL).
CLEF's director is Peter Bossaerts. At present, the main collaborators are Debrah Meloso and Jernej Copic at Caltech, Bill Zame at UCLA (director of UCLA's CASSEL laboratory), and Elena Asparouhova.at the University of Utah.
CLEF is financed by grants from the Jenkins Family Fund, the National Science Foundation, and Caltech (among others, through SISL, a Moore Grant and the William D. Hacker chair).