Experimental Asset Markets - Price Formation in the Presence of Ambiguity

Topic & Objectives

Almost all real-world situations in financial markets involve ambiguity, since the probabilities of possible market outcomes are mostly unknown. In this project, we investigate how the presence of ambiguity affects price formation and trading behavior in financial markets. We analyze the information transmission in financial markets in a dynamic setting where the level of ambiguity changes over time, due to the arrival of new information, and where agents are heterogeneous with different beliefs and different attitudes towards ambiguity.

The project is a continuation of our previous SAFE projects, which investigated ambiguity at the level of individual investors. In the previous projects, we studied individual beliefs and individual attitudes towards ambiguity, as well as the individual learning process about the true distribution as new information arrives. The results of these projects have been published in three SAFE Working Papers. In the current project, we take the analysis to the market level and investigate how different individual beliefs about the set of possible priors and different individual attitudes towards ambiguity are aggregated in a market context and lead to different market outcomes in the presence of ambiguity.

The analysis is performed with experimental asset markets, set up in the FLEX laboratory. The experiments use differentsettings regarding the presence of ambiguity and the gradual resolution of ambiguity with the arrival of new information. The obtained trading data are used to analyze the effect of ambiguity on various market outcomes (the price level, volatility, trading activity, and market liquidity) and to test the quality of popular empirical market-based measures for the degree of ambiguity.

Key Findings

• Ambiguity decreases market prices and trading activity.
• Ambiguity leads to lower market liquidity through wider bid-ask spreads.
• Popular market-based measures of ambiguity used in the empirical literature do not seem to correctly capture the true degree of ambiguity.

Policy Implications

• Transparency requirements in financial markets that lead to a reduction of ambiguity are beneficial.