Chapter 4 Experimental Random Arrival Markets with Competing Insiders
4.2 Background and Trading Environment
(Forsythe & Lundholm, 1990) examine a trading environment in which insiders are asymmetrically informed about the dividend payment of a risk asset. They find that trading in such markets can achieve a rational expectations equilibrium provided traders have sufficient trading experience and the structure of dividend payments are
commonly known.
(Holden & Subrahmanyam, 1992) and (Back, Cao, & Willard, 2000) study a theoretical environment in which multiple insiders all have the same information. They show that when such is the case, there does not exist a stable equilibrium trading strategy among competition insiders. If all insiders are equipped with identical
information, all insiders will rush into the market to grab informational rents, pushing prices to the full information price and exhausting informational rents.
(Kyle, 1985), on the other hand, shows that when information is held about a common liquidation value by a single insider, then the insider will act on his information
gradually, accumulating inventory, and revealing his information through signed order flow linearly over time.
(Miller, Plott, & Smith, 1977) study an environment in which supply and demand parameters shift at random between seasons. In their experiments, some traders could become informed about future supply and demand. They find that intertemporal speculation between seasons reduces price differences in both seasons towards the intertemporal competitive equilibrium.
The trading environment we study here is a modification of the Random Arrival (RA) market found in (Alton & Plott, Working Paper1) and (Alton & Plott, Working Paper2). An important feature of RA markets is the Flow Competitive Equilibrium (FCE) price, which is an induced common value similar to the “consensus value” of (Goettler, Parlou, & Uajan, 2005). Buyers and sellers arrive to the market each having private valuations which are symmetrically distributed around the FCE price. That is, each trader’s valuation for the asset is determined both by a common value and an idiosyncratic component. Idiosyncratic components of traders’ valuations provide incentives to trade similar to “noise traders.”
Uninformed traders receive a stream of private offers to buy or sell shares of an asset, “X,” to or from the experimenter. These offers are sent to participants according to a Poisson process and last for 6 minutes before they expire. The price associated with each private offer is equal to the FCE price, plus or minus a random amount drawn from a distribution of potential values.
Informed traders, on the other hand, have no private markets and hence no idiosyncratic reasons for trade. Their payoff is based solely on their ability to buy low and resell high using their inside information. Insiders know the rate of arrival and distribution of incentives of the uninformed traders. Using this information, insiders can compute supply and demand curves and equilibrium prices. For example, if private offers to buy and sell arrived to the market at a rate of 4 offers per minute, and the offers were distributed uniformly between 0 and 200 for the first half of the experiment and uniformly between 200 and 400 for the second half. Figure 4.1 shows this
graphically. The way in which supply and demand changes in these experiments is similar to (Miller, Plott, & Smith, 1977), which studies intertemporal competitive equilibrium in markets with random, seasonal fluctuations in demand and traders can purchase “foreknowledge” of future demand and supply.
Figure 4.1: Supply and Demand Curves
Given the above parameters, the FCE prices for the first and second half of the experiment would be 100 francs and 300 francs respectively, and trade would occur at a rate of 2 trades per minute. For a more detailed explanation of the FCE price, see (Alton
& Plott, Working Paper1).
Since insiders know that prices will be higher in the second half of the experiment, the problem they face is that they would like to buy cheap units at the beginning of the experiment and sell them for more money during the second half. This type of speculation shifts the demand curve to the right during the first half of the experiment, and shifts the supply curve to the right during the second half as seen below:
0 1 2 3 4
0 50 100 150 200 250 300 350 400
Period 1 Parameters
Price
Rate of Trade (trades per min)
0 1 2 3 4
0 50 100 150 200 250 300 350 400
Period 2 Parameters
Price
Rate of Trade (trades per min)
Figure 4.2: Speculation Between low and High Equilibria
This raises prices in the beginning of the experiment, and lowers prices during the second half of the experiment, cutting into insiders’ profits. If the insiders compete so aggressively that they drive prices up to 200 francs in the first half, and down to 200 francs in the second half, they won’t make any profit off their information. In this example, 200 francs is the insiders’ “break-even point.” In each experiment, insiders are explicitly told what the “break-even point” is for that experiment.
Another problem for informed traders is that uninformed traders may also be observing traded price levels relative to their own private incentives. These uniformed traders may try to learn about the parameters of the market from the insiders’ actions and begin to speculate themselves, cutting into insiders’ profits even further.
0 1 2 3 4
0 50 100 150 200 250 300 350 400
Period 1 Parameters
Price
Rate of Trade (trades per min)
0 1 2 3 4
0 50 100 150 200 250 300 350 400
Period 2 Parameters
Price
Rate of Trade (trades per min)
Multiple experiments were run on each date, and insiders designations were randomly shuffled between each period. Each experiment date also included a practice period, which we also report, in which there was only a single FCE price and all subjects were informed about what that price was. Subjects earned no money during the practice period.