Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Circuit Breakers with Uncertainty about the Presence of Informed Agents: I Know What You Know ... I Think

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Circuit Breakers with Uncertainty about the Presence of Informed Agents: I Know What You Know ... I Think

Article excerpt

Abstract: This study conducts experimental asset markets to examine the effects of circuit breaker rules on market behavior when agents are uncertain about the presence of private information. Our results unequivocally indicate that circuit breakers fail to temper unwarranted price movements in periods without private information. Agents appear to mistakenly infer that others possess private information, causing price to move away from fundamental value. Allocative efficiencies in our markets are high across all regimes. Circuit breakers perform no useful function in our experimental asset markets.

JEL classification: D82; G18

Key words: circuit breaker, experimental asset markets, trading interruption, private information

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This study examines the effect of circuit breakers on market behavior when agents are uncertain about the presence of private information. In our experimental asset markets traders know the probability that there is private information in the market. We investigate whether market-wide trading halts play a useful role in moderating unwarranted price movements in periods without private information. These periods are particularly interesting because all trade is uninformative but some traders may erroneously infer otherwise. If some agents mistakenly believe that there is private information in the market, they may mimic others' trading behavior, drawing still others in and causing asset prices to spiral away from fundamental value. Camerer and Weigelt (1991) provide some evidence of such information mirages (see also Anderson and Holt (1997)). We investigate whether circuit breakers dampen or prevent price movements away from fundamental value, particularly in periods in which private information is absent. (1)

Limited empirical research examines the role of circuit breakers in markets (Lauterbach and Ben-Zion (1993), Santoni and Liu (1993), and Goldstein and Kavajecz (2000)) because such studies are replete with challenges. (2) It is nearly impossible to isolate the effect of impediments to trade on market behavior using archival methods. Stock prices and associated volatility change for a variety of reasons that may or may not be related to shifts in underlying fundamentals. Archival methods also are unable to ascertain what would have happened in the absence of circuit breakers. Further, the NYSE circuit breaker rule has been activated only once since being instituted. However, recent research suggests that the probability of an extreme market movement is non-negligible (Booth and Broussard (1998), Bakshi and Madan (1999)). (3) Thus, significant issues remain unresolved.

With an experimental method we can control the distribution of information across traders and time and conduct an investigation that cannot be completed using data from naturally occurring markets. We are able to compare market outcomes under three circuit breaker regimes: market closure, temporary halt, and no interruption. Ackert, Church, and Jayaraman (2001) provide some recent experimental evidence on the effect of a circuit breaker rule. In their experiment, a subset of agents always receives private information about asset value. By design, asset prices should move away from an uninformed expectation toward an informed one as information is disseminated. Ackert, Church, and Jayaraman conclude that a circuit breaker rule does not inhibit price movement toward the informed price, though agents advance trade in anticipation of a breaker being triggered.

In the current study, circuit breakers may have the beneficial effect of mitigating unwarranted price movements. In periods without a subset of informed agents, asset prices should not deviate from the uninformed expectation. But uninformed agents do not know whether others' actions reflect informed or uninformed trade, and they may incorrectly infer that price signals are informative. If agents mistakenly believe that others' actions reflect private information, circuit breakers may temper deviations from fundamental value. …

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