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Stock Market as a 'Beauty Contest': Investor Beliefs and Price Bubbles sans Dividend Anchors

Author

Listed:
  • Shinichi Hirota

    (Graduate School of Commerce)

  • Shyam NMI Sunder

    (School of Management)

Abstract

We experimentally explore if the absence of dividend anchors (from which investors can backward induct to arrive at the fundamental value) may help us understand the formation of security price bubbles. The fundamental value models assume that the investors (a) form rational expectations, (b) form higher-order beliefs, (c) the security matures in finite time, and (d) that these three conditions are common knowledge among the investors. We argue that when the deviation of security markets from these assumptions deprives the investors of any reasonable way of backward inducting the fundamental value of a security from its future dividends, its price is susceptible to floating freely. We create laboratory markets with exogenously and endogenously specified terminal values, and examine whether the absence of a dividend anchor generates price deviations from the fundamentals. We find that such deviations occur in sessions where it is difficult for investors to backward induct value from dividends. Bubble price levels appear to be indeterminate, and price predictions follow a first-order adaptive or trend process. These processes are consistent with the conjecture that the investors resort to forward induction when backward induction becomes difficult or impossible. Under these conditions, the allocative efficiency and the cross-sectional dispersion of wealth also become indeterminate, as compared to high efficiency and low dispersion in the absence of bubbles.

Suggested Citation

  • Shinichi Hirota & Shyam NMI Sunder, 2002. "Stock Market as a 'Beauty Contest': Investor Beliefs and Price Bubbles sans Dividend Anchors," Yale School of Management Working Papers ysm271, Yale School of Management.
  • Handle: RePEc:ysm:somwrk:ysm271
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    Cited by:

    1. Lagoarde-Segot, Thomas & Lucey, Brian M., 2008. "Efficiency in emerging markets--Evidence from the MENA region," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 18(1), pages 94-105, February.
    2. Virtudes Alba Fernández & Pablo Brañas Garza & Francisca Jiménez Jiménez & Javier Rodero Cosano, 2003. "Teaching Nash Equilibrium and Strategy Dominance: A Classroom Experiment on the Beauty Contest," Economic Working Papers at Centro de Estudios Andaluces E2003/47, Centro de Estudios Andaluces.
    3. Gode, Dhananjay (Dan) K. & Sunder, Shyam, 2004. "Double auction dynamics: structural effects of non-binding price controls," Journal of Economic Dynamics and Control, Elsevier, vol. 28(9), pages 1707-1731, July.
    4. Pyemo N. Afego, 2013. "Stock Price Response to Earnings Announcements: Evidence From the Nigerian Stock Market," Journal of African Business, Taylor & Francis Journals, vol. 14(3), pages 141-149, December.
    5. Pyemo Afego, 2012. "Weak Form Efficiency of the Nigerian Stock Market: An Empirical Analysis (1984 2009)," International Journal of Economics and Financial Issues, Econjournals, vol. 2(3), pages 340-347.
    6. Charles Noussair & Steven Tucker, 2006. "Futures Markets And Bubble Formation In Experimental Asset Markets," Pacific Economic Review, Wiley Blackwell, vol. 11(2), pages 167-184, June.
    7. Okotori, Tonprebofa & Ayunku, Peter, 2019. "An empirical investigation on efficient market test for the Nigerian stock exchange (NSE)," MPRA Paper 110516, University Library of Munich, Germany.
    8. Barton, Jan & Waymire, Gregory, 2004. "Investor protection under unregulated financial reporting," Journal of Accounting and Economics, Elsevier, vol. 38(1), pages 65-116, December.

    More about this item

    Keywords

    Stock Price Bubbles; Beauty Contests; Common Knowledge; Market Experiments;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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