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The dynamics of trader motivations in asset bubbles

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  • Gunduz Caginalp

    ()

  • Vladimira Ilieva

    ()

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    Abstract

    Asset market experiments are analyzed by distinguishing, ex post facto, participants who trade on fundamentals versus those who trade on momentum (i.e., buying when the price is rising). The distinction is made when prices are above fundamental value, so that (in each period) those who have more offers than bids (net offerers) are classified as fundamentalists while those who have more bids than offers (net bidders) are defined to be momentum players. By analyzing the data of individual behavior we are able to address a number of key questions regarding bubbles. We find evidence that the cash supply of the momentum traders diminishes and the cash supply of the fundamental traders increases as the bubble forms. This suggests that the bubble is fueled by the cash of the momentum players and the reversal is caused by inadequate cash in their possession. These data are used in conjunction with a difference equation for price dynamics for two groups. The momentum traders exhibit a positive coefficient for price derivatives and a very small negative coefficient for trading based upon the deviation from fundamental value. Surprisingly, however, the fundamental traders, who exhibit a positive coefficient for trading on valuation, also exhibit a significantly positive coefficient for trend based buying. Thus, even those who are net offerers, classified as fundamentalists, are selling less and buying more of overvalued stock when there is a strong positive recent price change. There is also evidence that some fundamentalists change strategy to momentum trading as prices soar. An additional result is that the trend coefficient of the momentum traders vanishes with the implementation of an “open book” that allows traders to see all trades as they are entered.

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    Bibliographic Info

    Paper provided by University of Siena in its series Labsi Experimental Economics Laboratory University of Siena with number 008.

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    Date of creation: Aug 2006
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    Handle: RePEc:usi:labsit:008

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    Related research

    Keywords: Experimental economics; Asset markets; Behavioral finance; Momentum traders; Fundamental traders;

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    1. Cars Hommes & Joep Sonnemans & Jan Tuinstra & Henk van de Velden, 2003. "Coordination of Expectations in Asset Pricing Experiments," Tinbergen Institute Discussion Papers 03-010/1, Tinbergen Institute.
    2. Lei, Vivian & Noussair, Charles N & Plott, Charles R, 2001. "Nonspeculative Bubbles in Experimental Asset Markets: Lack of Common Knowledge of Rationality vs. Actual Irrationality," Econometrica, Econometric Society, vol. 69(4), pages 831-59, July.
    3. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August.
    4. Sonnemans, J. & Hommes, C.H. & Tuinstra, J. & van de Velden, H., 1999. "The Instability of a Heterogeneous Cobweb economy: a Strategy Experiment on Expectation Formation," CeNDEF Working Papers 99-06, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
    5. Robert Vigfusson, 1996. "Switching Between Chartists and Fundamentalists: A Markov Regime-Switching Approach," International Finance 9602003, EconWPA.
    6. Reitz, Stefan & Westerhoff, Frank, 2003. "Nonlinearities and Cyclical Behavior: The Role of Chartists and Fundamentalists," CFS Working Paper Series 2003/10, Center for Financial Studies (CFS).
    7. Lux, Thomas, 1998. "The socio-economic dynamics of speculative markets: interacting agents, chaos, and the fat tails of return distributions," Journal of Economic Behavior & Organization, Elsevier, vol. 33(2), pages 143-165, January.
    8. repec:cup:macdyn:v:8:y:2004:i:5:p:596-616 is not listed on IDEAS
    9. J. Doyne Farmer & Shareen Joshi, 2000. "The Price Dynamics of Common Trading Strategies," Working Papers 00-12-069, Santa Fe Institute.
    10. Frank Westerhoff, 2003. "Multi-Asset Market Dynamics," Computing in Economics and Finance 2003 88, Society for Computational Economics.
    11. Smith, Vernon L & Suchanek, Gerry L & Williams, Arlington W, 1988. "Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets," Econometrica, Econometric Society, vol. 56(5), pages 1119-51, September.
    12. David Porter & Vernon Smith, 1994. "Stock market bubbles in the laboratory," Applied Mathematical Finance, Taylor & Francis Journals, vol. 1(2), pages 111-128.
    13. Brock, William A. & Hommes, Cars H., 1998. "Heterogeneous beliefs and routes to chaos in a simple asset pricing model," Journal of Economic Dynamics and Control, Elsevier, vol. 22(8-9), pages 1235-1274, August.
    14. Lux, T. & M. Marchesi, . "Volatility Clustering in Financial Markets: A Micro-Simulation of Interacting Agents," Discussion Paper Serie B 437, University of Bonn, Germany, revised Jul 1998.
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