An Experimental Market for the Classroom to Test if Speculators Stabilize Prices

1
An Experimental Market for the Classroom to
Test if Speculators Stabilize Prices
by Professor Maureen Kilkenny,Resource Economics
Department, University of Nevada (Reno)
Abstract This classroom activity addresses
popular questions asked by undergraduate students
in money banking or finance classes such as
One, how can one make money in financial
markets? (If the perfect market hypothesis holds
there are no unexploited profit opportunities. So
why do so many people even try?) Two, what do
the terms arbitrage, hedge, speculate,
derivative, volatility, expectation,
rate-of-return, and technical analysis
mean? Three, what are the effects of speculators
on market prices? In particular, this
experimental market classroom activity helps us
understand how speculation affects price
volatility. One of the earliest hypotheses,
Friedman argued that because bad speculators
(who buy high, and sell low) lose money and are
driven out of the market, on net speculative
behavior is price-stabilizing. Alternatively,
volatility is exacerbated when there are "too
many" speculators with "formula" expectations
(e.g., Grossman and Stiglitz, American Economic
Review 1980 Lesmond, Schill, and Zhou Journal of
Financial Economics February 2004 71(2)
349-80.)

• When to use this activity students should
  already know
• how to analyze a market (for real goods or for
  assets) using supply x demand analysis
• the importance of both the price now AND the
  price later in asset demand
• how to calculate a standard deviation
• how to calculate the rate-of-return

Handout 1 1) the previous class
meeting

• Experimental Market Do Speculators (de)Stabilize
  Prices? 1
• Is is possible that prices fluctuate more
  wildly because of the activity of "speculators"
  in markets? The purpose of this experimental
  market is to demonstrate the circumstances under
  which speculation reduces volatility. In
  particular, it shows that volatility is
  exacerbated when there are too many speculators
  with formula expectations.
• Producers or consumers who contract to sell
  or buy products at specified future dates in
  order to guarantee a price for the transactions
  they must make are hedging. In contrast, anyone
  who makes contracts to buy or sell with the
  purpose of profiting from expected differences in
  prices between periods are speculating. For
  example, the commodity buyer for a large food
  processor which holds inventories has both
  incentives. S/He needs to acquire the products
  as cheaply as possible, but s/he can also sell
  them to make a profit. S/He succeeds in her/his
  job if s/he (i) buys inputs cheaper than the
  company's competitors do, or, (ii) earns profits
  by arbitraging.
• Classroom Activity Participants choose either to
  buy OR to sell in the next period's market for a
  sequence of periods. Successful choices earn a
  100 rate of return. There is a binding budget
  constraint.
• Objective and Instruments Money can be made by
  "buying low, or selling high". Participants
  'bet' on the next period price in a way that
  also affects that price. Participants who expect
  the price to rise should "sell." If it indeed
  rises, they earn 1.00. If the price falls,
  those who took a "buy" position earn.
• Constraints There is an exogenous fundamental
  spot price sequence. Participants observe six
  past realizations of the spot price, and the
  subsequent spot prices after each period market
  clears. The 'market-clearing' spot price is a
  weighted average of the period's fundamentals and
  the period's excess speculative demand. Budget
  constraint each participant is given an initial
  endowment of one dollar. Each must pay 1.00 for
  a contract to buy or sell each period.
  Participants with no more endowed or won
  dollars cannot take positions in the market.
• Mechanics Each participant gets an envelope
  containing one dollar, one green "SELL" card, and
  one gold "BUY" card. Write your own name on the
  outside of the envelope you receive.
• ? There is one "practice/dry run" bidding
  session in which no money is paid or won.
• ? Put a dollar and the card of your choice into
  the envelope pass your envelope to the
  auctioneer.
• The auctioneer will tally all the buy
  and sell contracts, and will adjust the
  fundamental price
• upward if buy contracts exceed
  sell contracts, and vice-versa.
• Then the auctioneer reveals the new
  spot price.
• All buy contracts win if the market price falls
  from the previous price (and all sell contracts
  lose).
• All sell contracts win if the market price has
  risen (and all buy contracts lose).

Speculators make money by "buying low, selling
high." Friedman's Hypothesis Stabilizing
Speculators Make Money De-stabilizing
Speculators Lose money De-stabilizing
Speculators are driven out of the market ?
Speculation is stabilizing
Distribute the envelopes containing one dollar,
one GOLD card, and one GREEN card (3)
The first overhead (2)
The second overhead (4)
2
The third overhead (5) mechanics
Transcripts of selected (spell-checked but
unedited) homework answers 1) What I learned
from the classroom experiment The experiment
in class was designed to demonstrate the activity
of a market when speculators were introduced. The
class showed that in the beginning of the
experiment when there were a number of
speculators in the market that the speculative
behavior increased the market volatility. As the
experiment weeded out the "de-stabilizing"
speculators the volatility wasn't as large as it
was in the beginning. Toward the end of the
experiment, speculation provided to be
stabilizing. The actual market fluctuations were
greater without speculations, then they were with
it. So overall I learned that speculators who go
against the market "buy high, sell low" truly do
destabilize the market causing wilder
fluctuations, and I learned that speculators who
move with the market "buy low, sell high" tend to
stabilize the market over time. One thing I
learned is to buy low and sell high and try to go
against the majority. I was one of the many
de-stabilizing speculators who left the market
early. I think if we were supplied with more
information some of the speculators would of had
better luck. Trying to guess what the price would
do and what the other speculators would do made
it very easy to leave the market early.
Speculators have to think about the price and
other speculators. From the in-class
experiment I learned that no matter what "past"
information you have acquired, a speculative into
the future is always unpredictable. I survived
the first part of the experiment by looking for a
trend, in which I thought the price would rise or
fall. However I was pushed out of the market as
the volume fell, because I was not sure when the
price had topped out and was on the decline.
If I learned anything from the class experiment
on speculators in futures markets it's that
inexperienced speculators taking guesses on
changes in prices seem to increase the volatility
in the market. The experiment also easily showed
how demand and supply affect market prices. I
learned that you want to do the opposite of what
everyone else in the market is doing. The past
performance of a stock does not indicate the
future. The third thing I learned was that future
prices are unpredictable. From the in-class
experiment I learned that speculation can either
reduce volatility or increase volatility. If too
many speculators have determined expectations the
volatility will increase. I also learned what
hedging and speculating mean. Hedging is when
producer/consumers contract to sell or buy
products at a specified future date in order to
guarantee a price for the transaction.
Speculating is when a person makes a contract to
buy or sell with the main purpose of profiting
from the expected differences in prices.
The fourth overhead (6) spot price series
(quarterly hog prices, 1948-52)
record transactions (live) (7)
participants gold cards, envelopes in next
round
The so called "destablizing speculators" such as
myself who sell low don't necessarily bring the
market down. It does though force them out. Past
success is no guarantee that a speculator will do
well in the future, or next decision, since
future prices are unpredictable. The investment
dartboard and the random walk theory back this
up. From the classroom experiment I learned
if you can know what the majority of the
investors are going to do you can make money. If
they think prices are going to drop you want to
sell and if you think they think are going to
rise in the next period you want to buy. From
the classroom experiment I learned that the act
of speculation has a effect on securities
markets. Market speculation was shown to actually
stabilize prices in the market. This was shown at
the end of class when the effect of speculation
on stock prices was compared with the fundamental
price series. On Tuesday, we conducted an
experimental market consisting of 22 speculators
(fellow classmates) to test if speculators
stabilize prices. We were given a choice to buy
or sell on forward markets. At the end of the
experiment, I realized that speculative behavior
increases volatility of market price at the first
periods (it destablized market prices). At the
end of the trading, the volatility or changes
decreases. Speculators are basically paying for
those winning speculators. I learned that no one
can accurately determine the market and
speculators make mistakes. I learned from the
classroom experiment that 1) Random-walk
behavior of stock prices support the efficient
markets theory. You can't beat the market with
the analysis the previous performances and
historical data. 2) When there are "too many"
speculators with "formula" expectations, then
volatility increases.