Eperimential Economics Research On Stable Mechanism In Security Market

In traditional asset pricing research, most academic study regards trading mechanisms as exogenous variables, and asserts that trading mechanisms are not important to the process of price formation. But with the development of market microstructure theory, a lot of research indicates that trading mechanisms have great influence on market volatility, liquidity, transparency and efficiency. Market stability mechanisms are an important part of market microstructure. Market stability mechanisms are tools used by exchange and supervision institutions to deal with severe price volatility in financial market. They have a great effect on market liquidity, volatility and transparency. Since the stock market crash of October 1987, several markets have set up price-stability mechanisms such as circuit breakers and price limits to control the excessive fluctuation of stock prices.However there is a keen debate about the economic function and implicit costs and benefits of stability mechanisms in the academic field. Advocates and opponents both put forward theories and empirical evidence to support their views. Why are there so many arguments over the theoretical analysis and empirical research on the stability mechanism? The key point lies in the special characteristics relating to how this problem is studied. Harris (1998) pointed out that the previous research had shortcomings since we could not simulate a market without price limits. Hence, Harris said,"market stability mechanisms (especially price limits) have their greatest effect on the stock market, even though we know very little about them."With the development of experimental economics, more and more researchers acknowledge that the experimental method may be a good way to study market stability mechanisms. Experimental economics involves studying a certain economic phenomenon by controlling experimental conditions, observing the participator's behavior and analyzing experimental results. Hence researchers are able to check, compare and perfect economic theory. In 2002, Professors Kahneman and Smith were rewarded with the Nobel Prize, and experimental economics has attracted more and more recognition. We can now say that experimental economics is part of main stream economics.The history of the use of the experimental method in finance research is not long. Although experimental economics has developed considerably and is widely applied abroad, it is still a quite a new subject in China, and has great potential. Currently, experimental economics is developing quickly in China and a lot of researchers are interested in the subject. With the support of the National Science Fund, Joint Research Project of the Shanghai Stock Exchange and Smith Experimental Economics Research Center of Shanghai Jiaotong University, we undertook some research into the securities market stability mechanisms.Since there is no way to keep other factors unchanged in order to measure market stability mechanisms in a real financial market, the only way to do this is by controlled experimentation. When we do a market stability mechanism experiment, we can keep other factors unchanged and simplified. In order to study the function of the market stability mechanism, we can compare a market with that has a market stability mechanism with a market that does not.In the first part of the study, we experimented on an important stock market stability mechanism called a circuit breaker. Following the approach of Ackert, Church and Jayaraman (2001),we did a correction on the stock market in China, and design the experiment so that the experiment is easy to do. We did nine experiments to check the impact of market stability mechanisms on the stock market. In our experiments, there are two circuit breakers: one is a"trading stop"and the other is a"trading halt". A"Trading stop"means the market may be closed when the market is in a volatile state, that is, once the circuit breaker is triggered, the market will be closed until the next trading period (such as next trading day). A"Trading halt"means that the market may be temporary closed for certain time. That is, once the circuit breaker is triggered, market will be closed for a certain time, and then the market will be re-opened and traders can trade again. We regard the market where there is no circuit breaker as the benchmark. We do experiments under these three market states, analyze the data obtained from the experiments, then study the operational efficiency of circuit breakers and the impact on market price, trading behavior and other related topics.In the second part of our study, we examined another important market stability mechanism -- price limits. Our experiment was based on Krahnen, Rieck and Theissen (1999), but redesigned to make sure the experiment was meaningful to our market. We did four experiments, in which two experimental markets had price limits and the other two have no price limit.The main research conclusions were:a. Market circuit breaker(1) Whether or not there is a market circuit breaker, the market price as a whole converges to the expected stock value, which is determined by all the information (public information and private information). But under circumstances where the circuit breaker exists, the convergence is constrained, which slows the speed at which equilibrium is reached in the long run. Especially in the situation where the circuit breaker was set as the"trading halt", the convergence process was always stopped by the trade pause, which affected the speed at which the price reached the equilibrium. However, comparing this situation to the"trading stop", the closing price will be closer to the inherent value of the stock. From the viewpoint of arbitrage opportunity, because the market stability mechanism blocks the further process of the trade, holding back the diffusion of the information in the market, some special arbitrage opportunities can exist in the market. Depending on the different market circuit breaker mechanisms, the closing price results in different deviations from the inherent value of the stock. Compared to other stability mechanisms, the"trading stop", caused the biggest deviation between price and basic value. Free trading without the stability mechanism brought the price closer to the basic value.(2) The introduction of the stability mechanism reduces market activity, seeing a decrease in the trading volume of the whole market. The market with no stability mechanism had the biggest trade volume in the experiment, while the market with the"trading stop"had the least volume. But after considering the trade time factor, the stability mechanism stimulated trading activity before the circuit breaker was triggered. Before the circuit breaker is triggered, the market trade volume per unit of time is higher than that in the market without a stability mechanism.(3) The information advantage of the trader can bring them some excess income. The results of this experiment illustrate the importance of information in stock trading. Although the information advantage of informed traders is only revealed in the B period in every trade year, and it only includes a probable estimation of the future inherent value of stocks, this information advantage is enough to let those investors get higher proceeds than others. Other than the information states of the investors, the stable mechanism is a significant factor that influences the proceeds. The possible reason may be as follows. Informed traders buy (or sell) a large volume of stocks based on good (or bad) news, causing the increase of the probability that the circuit breaker will be triggered. Once the market trade is suspended or is stopped, the uninformed traders realize that informed traders have learnt significant good (or bad) news, so the price will quickly reach the inherent value, reducing the profitability of the informed traders.b. Price limits(1)The performance difference of traders caused by information asymmetry is relatively significant, and this difference will be more obvious when there is no price limit. The quote prices of informed traders consider both private information and the market price of last trade, while the quote prices of uninformed traders are mainly based on the market price of the last trade. When there are price limits in the market, the quote prices are restricted to fluctuating in a limited space. Although the quote prices of informed traders are still affected by private information, this influence is smaller. The possible reason is that, the price limit makes informed traders unwilling to state their desired prices, preventing the informed traders revealing all the private information on their quote prices.(2) When the stability mechanism is unchanged (commonly with price limit or commonly without price limit), the thought processes of traders have consistency: traders tend to be rational when the market has no price limit, and they tend to be shortsighted when the market has price limits. So price limits may influence the rationality of the traders in quoting.(3) From the perspective of the information-transfer efficiency of market prices, whether or not there are price limits, the market has some degree of inefficiency. This result is similar to the results of Krahnen et al. (1999). As to the quantitative information efficiency, the swing range of the capital value has close relation with the information-transfer efficiency of the market. The bigger the swing range, the less the information-transfer efficiency of the market.(4) With or without price limits, the average proceeds of informed traders were more than uninformed traders, but there was not a statistically significant difference between the two scenarios. In different market mechanisms, the reason for this result may be different. If there is no price limit, in order to use their private information, informed traders may be too anxious to buy or sell stocks and make the buying or selling decision too early, causing them to lose some wealth. If there are price limits, informed traders are somewhat constrained in using their private information, causing a decrease in the efficiency of the transfer of market information.From these experiments, market stability mechanisms, whether market circuit breakers or price limits, will have some influence on the operation of the stock market. According to our research results, we believe that the market stability mechanism is a two-edged sword, having both positive and negative effects:(1) Price limits can stabilize market fluctuation to some degree, and should be reserved, but can actually result in an increased price range. Price limits can control the fluctuation of stock prices but can also lower the efficiency of market information transfer and lower the rationality of the thought processes of investors. In China's stock market's condition, the daily stock price limit could be loosened to some degree to reduce the probability of the stock price getting to the limited price, so as to reduce the negative influence of this mechanism.(2) The circuit breaker need not be introduced as a stability mechanism to China's stock market on the current condition. Compared to price limits, the"trading pause"or"trading stop"circuit breakers are a more severe mechanism. From the results of experiments, this method significantly influences pricing efficiency, and slows the speed at which the market price reaches its equilibrium. Therefore, we do not suggest this kind of market stable mechanism.