Elena Asparouhova, Ph.D. - US grants

Competitive financial markets play an absolutely central role in the economy. They provide the means by which society shares risk and allocates capital. Existing theoretical models of such markets are elegant and beautiful, but fare badly when confronted with actual data. The work proposed uses laboratory experiments to explore several possible explanations for the disconnection between theory and fact: (a) that some agents are better informed than others, (b) that some agents do not use available information as well as others, and (c) that some agents suffer from cognitive biases.

This work shows that experiments can play a role in finance entirely analogous to the role they play in the physical sciences, making it possible to create and study complicated systems in a controlled setting, eliminating "frictions" and noise, studying the effect of changing a few variables while holding others constant, and exploring counterfactuals. The insights to be gained from this research have implications for investment and for government policy and regulation, including social security.

In this research project, the PIs investigate the possibility that social rationality explains the emergence of one type of bubble in competitive asset markets: a bubble referred to as a "credit market bubble." The bubble is defined as a situation where (i) the debt is priced above its commonly known intrinsic value and (ii) the debt is rolled over even though each creditor should cash in because everyone knows that the debtor will never be able to repay. Building on evidence from behavioral game theory, the PIs conjecture that such credit market bubbles emerge whenever the debtor's payment ability, although never sufficient, grows over time. Pilot experimental data confirm the emergence of bubbles in this setting. The researchers will conduct experiments to further examine the robustness of bubbles in this environment and test the hypothesis that norms are driving the observed behavior.

In terms of broader impacts, this research will provide a better understanding of price bubbles. Credit bubbles and accompanying asset price run-ups re-occur with alarming frequency in the real world. This research suggests that tension between individual and social rationality is the root cause for their existence. It will lead to a better understanding of this ubiquitous phenomenon in modern capitalist society, and inspire novel and effective government policy and regulation to minimize their negative effects.

Starting with Chamberlin in the 40s, experiments with markets have made economists pessimistic about the merits of decentralized markets, in sharp contrast with centralized markets. The centralized continuous double auction has emerged as the mechanism most advocated by economists to generate the beneficial outcomes associated with competitive equilibrium. Buttressed by recent advances in theoretical modeling of decentralized markets, our experiments have started to paint a different picture, with decentralized markets generating outcomes that are not much different from those of centralized markets. Here, we propose to investigate the very dimension in which decentralized markets have been proposed to improve upon centralized markets, namely, in providing sustained incentives to pay for (inside) information (within the right economic setting, of course) the theory does not claim that decentralized markets will always be better). This contrasts with centralized markets, which theory and experiments have argued lead to the Grossman-Stiglitz paradox (if information is costly, prices cannot be informative). The negativity with which economists generally depict the workings of decentralized markets has affected policy making, certainly since the Great Financial Crisis, to the extent that such markets are now generally shunned, or even, as in the recent European directive MiFID 2, disallowed. Our experiments are meant to bring hard evidence to the table. They should illustrate the possibility of evidence-based policy making in finance.


Decentralized financial markets have been deemed detrimental to efficient and fair pricing because of their lack of transparency (whence the synonym "dark markets"). Recent legislation in both the U.S. and in the E.U. is gradually forcing all trading onto centralized markets, or multilateral trading platforms, where everyone can see, in a timely fashion, pretty much everything that is going on (order submission, executed trades, etc.). However, controlled experiments with financial markets have confirmed a theoretical prediction from the 70s, which is that centralized markets fail to provide incentives to collect information (when this is costly) and hence, centralized markets can at best generate only noisy prices. In contrast, more recent theoretical modeling argues that in certain settings, decentralized markets would actually generate the right incentives, and as a result, prices would be more accurate than in centralized markets. If this is true, the gradual elimination of "dark markets" might not have been a good policy. We propose to study price discovery with costly information acquisition in decentralized markets through controlled experimentation. Our experiments would advise whether recent financial markets regulation may have to be re-examined. While inspired by theoretical reasoning, our recommendation will be evidence-based, and as such, would break with the tradition in rule making in finance, which has been almost entirely model-based.

Asset pricing theory has recently been criticized for its inability to explain historical data from field markets. Yet its poor record does not mean that it is scientifically invalid. Our experience (as experimentalists) is that theorists are not aware of the scientific record of asset pricing theory (how well it works in a controlled setting). The aim of the workshop is to sensitize theorists to this record. It should make them aware not only of the successes (of the theory), but also of where the theory fails (and how the failures can be addressed). It is hoped that the workshop heralds a new era where theorists work in closer collaboration with experimentalists. The PIs have a long track record not only in financial markets experimentation, but also in the experimental method in general (having contributed successfully to neuroscience), and they have published in asset pricing theory. As such, they are uniquely positioned to moderate the proposed dialogue between theorists and experimentalists.

Financial economics is rather abstract and mathematical, and its value is difficult to ascertain from merely observing real-world financial markets, which operate in a complex environment where many key variables either remain unobserved or cannot be measured reliably. In the last decade, however, tools have been developed to study financial markets in the laboratory, where real people trade for real money. The controlled setting is designed to emulate the theoretical context and as such has proven to be an ideal testing ground. The workshop aims at bringing together theorists and experimentalists in order to start a dialogue. Experimentalists are to be taught what aspects of the theory are defining, and hence, need to be tested, and theorists are to be encouraged to explain their models in terms of experiments with which to gauge scientific validity, which requires theorists to understand the experimental approach. We thereby import into finance a longstanding tradition from the physical sciences. The goal is to move finance to an evidence-based discipline. This will ultimately benefit financial markets policy formulation and rule making, which until now have primarily been model-based, or in the rare occasions where the data were available, informed only by empirical analysis of historical data.