Abstract: We study how inflated credit ratings affect investment decisions in bond markets using experimental coordination games. Theoretical models that feature a feedback effect between capital markets and the real economy suggest that inflated ratings can have both positive and negative real effects. We compare markets with and without a credit rating agency and find that ratings significantly impact investor behaviour and capital allocation to firms. We show that the main mechanism through which these real effects materialize is a shift in investors’ beliefs about the behaviour of other investors rather than firms’ underlying fundamentals. Our experimental results suggest that the positive impact of inflated ratings is likely to dominate in the presence of feedback effects since ratings act as a strong coordination mechanism resulting in enhanced market outcomes.
Discussant: John Duffy, University of California-Irvine
Abstract: Indivisibilities in goods or services such as travel, insurance, cars, etc., have long been known to cause serious problems for (walrasian) equilibrium existence. One of the reasons is the assumption that agents fully optimize. This assumption is theoretically implausible and factually wrong since individual budget allocation problems under indivisibilities are "NP hard." Armed with recent advances into the drivers of human effort and performance in the 0-1 knapsack problem, we propose that markets may equilibrate after all because markets select price configurations that make agents' budget problems sufficiently difficult so that demand is stratified along levels of cognitive effort or capability. In a market experiment with 3 assets and cash, we find that markets settle -- despite the non-existence of Walrasian equilibrium -- at price levels that imply high computational complexity. This leads to lower earnings for participants who use only simpler algorithms (heuristics) when determining which assets to buy.
Abstract: We examine how the indexing strategy used by exchange traded funds (ETFs)
affects the prices of the underlying constituent assets. We study this issue in both
the primary market (ETF creations and redemptions using bots as authorized
participants) and the secondary market. The experiment includes three environ-
ments: (i) no ETF, (ii) an equal weighted ETF, and (iii) a market cap weighted
ETF. We find that ETFs significantly affect the value of the constituent assets,
in particular the value of assets that are in shortest supply.
Abstract: We hypothesize that individuals learn about their investment ability based on realized gains and losses
rather than overall portfolio performance. Thus, how investors sell their stocks, or how they remember
those sales, impacts their confidence. The disposition effect and self-serving memory leads to investor
overconfidence. We provide empirical evidence for this in (i) survey data and transaction records of Dutch
retail investors and (ii) an experiment for causality. In a final step, we outline a model that formalizes the
learning mechanism and how it leads to overconfidence as well as lower trading profits and higher volume.
