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Are Long-Horizon Expectations (De-)Stabilizing? Theory and Experiments

Author

Listed:
  • George Evans
  • Cars Hommes
  • Bruce McGough
  • Isabelle Salle

Abstract

Most models in finance assume that agents make trading plans over the infinite future. We consider instead that they are boundedly rational and may only form forecasts over a limited horizon. We explore how participants in financial markets trading over finite horizons affect the level and the volatility of the price. In our theoretical model, agents with different planning horizons may hold different expectations over those horizons and trade the asset accordingly. We derive testable implications in the lab under various theories of expectation formation over those horizons. Then we design a laboratory experiment to test these theoretical implications against human behaviour. Our experiment confirms most of our theoretical hypotheses. Short-horizon trading favors deviations of the asset price from fundamentals. By contrast, a modest share of long-horizon traders is enough for the price to stabilize around its fundamental value. This is because short-horizon traders tend to coordinate their price forecasts using non-fundamental factors, such as recent price trends, in choosing their trading strategies. Long-horizon traders hold more heterogeneous views about future price developments, which prevents such trend-chasing behaviour.

Suggested Citation

  • George Evans & Cars Hommes & Bruce McGough & Isabelle Salle, 2019. "Are Long-Horizon Expectations (De-)Stabilizing? Theory and Experiments," Staff Working Papers 19-27, Bank of Canada.
  • Handle: RePEc:bca:bocawp:19-27
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    References listed on IDEAS

    as
    1. William A. Branch & George W. Evans & Bruce McGough, 2010. "Finite Horizon Learning," University of Oregon Economics Department Working Papers 2010-15, University of Oregon Economics Department.
    2. Whitney K. Newey & Kenneth D. West, 1994. "Automatic Lag Selection in Covariance Matrix Estimation," Review of Economic Studies, Oxford University Press, vol. 61(4), pages 631-653.
    3. Bullard, James & Evans, George W. & Honkapohja, Seppo, 2010. "A Model Of Near-Rational Exuberance," Macroeconomic Dynamics, Cambridge University Press, vol. 14(2), pages 166-188, April.
    4. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    5. Shinichi Hirota & Juergen Huber & Thomas Stock & Shyam Sunder, 2015. "Investment Horizons and Price Indeterminacy in Financial Markets," Cowles Foundation Discussion Papers 2001, Cowles Foundation for Research in Economics, Yale University.
    6. Sean Crockett & John Duffy & Yehuda Izhakian, 2019. "An Experimental Test of the Lucas Asset Pricing Model," Review of Economic Studies, Oxford University Press, vol. 86(2), pages 627-667.
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    Cited by:

    1. Airaudo, Marco, 2020. "Temptation and forward-guidance," Journal of Economic Theory, Elsevier, vol. 186(C).

    More about this item

    Keywords

    Asset Pricing; Central bank research; Economic models; Financial markets;

    JEL classification:

    • C92 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Group Behavior
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E70 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - General

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