Risk Preferences in Experimental Asset Markets: Are Markets Characterized by Rational Expectations?

Asbjørn Emil Holmlund & William Lønstrup-Kliim

Student thesis: Master thesis

Abstract

In this paper, we investigate traders’ risk preferences in the experimental asset markets presented by Haruvy, Lahav, and Noussair (2007) using estimated risk preferences from Holt and Laury (2002), in order to determine whether the assumption of risk neutrality in the markets seems reasonable. To accomplish this, we analyze whether markets converge to rational expectation in the sense of Muth (1961) (REM), which is defined as: (i) predictions are sustained by outcomes, and (ii) outcomes must support predictions from some theory (Smith et al., 1988). If traders have rational expectations, then prices will follow the assets’ intrinsic value, and since this value is defined partly by traders’ risk preferences it will allow us to examine them. Utilizing a rank dependent utility model, with expopower, Prelec probability weighting, and contextual errors, we estimate that subjects in Holt and Laury (2002) are risk averse. We use this estimated risk aversion in conjunction with the dividend distribution from Haruvy et al. (2007), to obtain an estimate for the risk-adjusted intrinsic value, which we expect the equilibrium price to follow if markets exhibit REM. Our principal findings are: (i) predictions are not sustained by prices, (ii) prices do not support predictions from the estimated risk-adjusted intrinsic value, however, we find evidence that they do support an intrinsic value slightly below the one expected under risk neutrality, and (iii) markets do not exhibit REM. We believe, that the reason why traders’ predictions are not supported by prices, and why we in turn do not find support for REM, is that we observe a bubble in all markets, indicating that markets have not reached common knowledge of rationality (Plott, 1961). Despite not finding support for REM, our result that prices support a slightly risk averse intrinsic value, indicates that the risk neutrality assumption in Haruvy et al. (2007) might not be justified.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2019
Number of pages94
SupervisorsMorten Lau