Creation and control of bubbles: Managers compensation schemes, risk aversion, and wealth and short sale constraints

Abstract

Persistent divergence of an asset price from its fundamental value has been a subject of much theoretical and empirical discussion. This chapter takes an alternative approach of inquiry – that of using laboratory experiments – to study the creation and control of speculative bubbles. The following three factors are chosen for analysis: the compensation scheme of portfolio managers, wealth and supply constraints, and the relative risk aversion of traders. Under a short investment horizon induced by a tournament compensation scheme, speculative bubbles are observed in markets of speculative traders and inmixed markets of conservative and speculative traders. These results maintain with super-experienced traders who are aware of the presence of a bubble.Abinding wealth constraint dampens the bubbles as does an increased supply of securities. These results are unchanged when traders risk their own money in lieu of initial endowments provided by the experimenter. The primary method of analysis is to use live subjects in a laboratory setting to generate original trading data, which are compared to their fundamental values. Standard statistical techniques are used to supplement analysis in explaining the divergence of asset prices from their fundamental values.