The goals of experimental finance are to understand human and market behavior in settings relevant to finance. Experiments are synthetic economic environments created by researchers specifically to answer research questions. This might involve, for example, establishing different market settings and environments to observe experimentally and analyze agents' behavior and the resulting characteristics of

trading Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market. An early form of trade, barter, saw the direct excha ...

flows, information diffusion and aggregation,

price setting Price fixing is an Anti-competitive practices, anticompetitive agreement between participants on the same side in a market to buy or sell a product (business), product, service, or commodity only at a fixed price, or maintain the market conditio ...

mechanism and

returns Return may refer to: In business, economics, and finance * Return on investment (ROI), the financial gain after an expense. * Rate of return, the financial term for the profit or loss derived from an investment * Tax return, a blank document or t ...

processes. Fields to which experimental methods have been applied include

corporate finance Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and anal ...

, asset pricing,

financial econometrics Financial econometrics is the application of statistical methods to financial market data. Financial econometrics is a branch of financial economics, in the field of economics. Areas of study include capital markets, financial institutions, corpo ...

international finance International finance (also referred to as international monetary economics or international macroeconomics) is the branch of financial economics broadly concerned with monetary and macroeconomic interrelations between two or more countries. Inter ...

, personal financial decision-making, macro-finance, banking and financial intermediation,

capital markets A capital market is a financial market in which long-term debt (over a year) or equity-backed securities are bought and sold, in contrast to a money market where short-term debt is bought and sold. Capital markets channel the wealth of savers to ...

, risk management and

insurance Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...

derivatives The derivative of a function is the rate of change of the function's output relative to its input value. Derivative may also refer to: In mathematics and economics * Brzozowski derivative in the theory of formal languages * Formal derivative, an ...

quantitative finance Mathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling of financial markets. In general, there exist two separate branches of finance that require ...

corporate governance Corporate governance is defined, described or delineated in diverse ways, depending on the writer's purpose. Writers focused on a disciplinary interest or context (such as accounting, finance, law, or management) often adopt narrow definitions th ...

and compensation, investments, market mechanisms, SME and

microfinance Microfinance is a category of financial services targeting individuals and small businesses who lack access to conventional banking and related services. Microfinance includes microcredit, the provision of small loans to poor clients; savings ...

and entrepreneurial finance. Researchers in experimental finance can study to what extent existing financial economics theory makes valid predictions and attempt to discover new principles on which theory can be extended. Experimental finance is a branch of

experimental economics Experimental economics is the application of experimental methods to study economic questions. Data collected in experiments are used to estimate effect size, test the validity of economic theories, and illuminate market mechanisms. Economic expe ...

and its most common use lies in the field of

behavioral finance Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory. ...

History

In 1948,

Chamberlin The Chamberlin is an electro-mechanical keyboard instrument that was a precursor to the Mellotron. It was developed and patented by the American inventor Harry Chamberlin from 1949 to 1956, when the first model was introduced. There are severa ...

reported results of the first market experiment. Since then the acceptability, recognition, role, and methods of experimental economics have evolved. From the early 1980s on a similar pattern emerged in experimental finance. The foundational work in experimental finance was the work of Forsythe,

Palfrey A palfrey is a type of horse that was highly valued as a riding horse in the Middle Ages. It was a lighter-weight horse, usually a smooth gaited one that could amble, suitable for riding over long distances. Palfreys were not a specific breed ...

and

Plott The Plott Hound is a large scent hound, originally bred for hunting bears. In 1989, the North Carolina General Assembly designated the Plott Hound as the official State Dog. The Plott Hound was first registered with the United Kennel Club in 194 ...

(1980), Plott and Sunder (1982), and

Smith Smith may refer to: People * Metalsmith, or simply smith, a craftsman fashioning tools or works of art out of various metals * Smith (given name) * Smith (surname), a family name originating in England, Scotland and Ireland ** List of people wi ...

, Suchanek and Williams (1988).

Scientific value

Financial economics has one of the most detailed and updated observational data available of all branches of economics. Consequently, finance is characterized by strong empirical traditions. Much analysis is done on data from

stock exchanges A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds and other financial instruments. Stock exchanges may also provide facilities for the ...

including bids, asks, transaction prices, volume, etc. There is also data available from information services on actions and events that may influence markets. Data from these sources is not able to report on expectations, on which theory of financial markets is built. In experimental markets the researcher is able to know expectations, and control fundamental values, trading institutions, and market parameters such as available liquidity and the total stock of the asset. This gives the researcher the ability to know the price and other predictions of alternative theories. This creates the opportunity to do powerful tests on the robustness of theories which were not possible from field data, since there is little knowledge on the parameters and expectations from field data.

Advantages

Financial data analysis is based on data drawn from settings created for a purpose other than answering a specific research question. This results in the situation where any interpretation of the results may be challenged since it ignores other variables that have changed. Traditional data analysis issues include

omitted-variables bias In statistics, omitted-variable bias (OVB) occurs when a statistical model leaves out one or more relevant variables. The bias results in the model attributing the effect of the missing variables to those that were included. More specifically, O ...

es,

self-selection bias In statistics, self-selection bias arises in any situation in which individuals select themselves into a group, causing a biased sample with nonprobability sampling. It is commonly used to describe situations where the characteristics of the peo ...

es, unobservable independent variables, and unobservable dependent variables.Bloomfield, Robert and Anderson, Alyssa
"Experimental finance"
. In Baker, H. Kent, and Nofsinger, John R., eds. Behavioral finance: investors, corporations, and markets. Vol. 6. John Wiley & Sons, 2010. pp. 113-131. Properly designed experiments are able to avoid several problems: Omitted-variables bias: Multiple experiments can be created with settings that differ from one another in exactly one independent variable. This way all other variables of the setting are controlled, which eliminates alternative explanations for observed differences in the dependent variable. Self-selection: By randomly assigning subjects to different treatment groups, the experimenters avoid issues caused by

self-selection In statistics, self-selection bias arises in any situation in which individuals select themselves into a group, causing a biased sample with nonprobability sampling. It is commonly used to describe situations where the characteristics of the peop ...

and are able to directly observe the changes in the dependent variable by changing by altering certain independent variables. Unobservable independent variables: Experimentalists can create experimental settings themselves. This makes them able to observe all variables. Traditional data analysis may not be able to observe some variables, but sometimes experimenters cannot directly elicit certain information from subjects either. Without directly knowing a certain independent variable, good

experimental design The design of experiments (DOE, DOX, or experimental design) is the design of any task that aims to describe and explain the variation of information under conditions that are hypothesized to reflect the variation. The term is generally associ ...

can create measures that to a large extent reflects the unobservable independent variable and the problem is therefore avoided. Unobservable dependent variables: In traditional data studies, extracting the cause for the dependent variable to change may prove to be difficult. Experimentalists have the ability to create certain tasks that elicit the dependent variable.

Types of experiments

Laboratory experiments

Laboratory experiments are the most common form of experimentation. Here the idea is to construct a highly controlled setting in a laboratory. The use of lab experiments increased due to growing interest in issues such as economic cooperation, trust, and

neuroeconomics Neuroeconomics is an interdisciplinary field that seeks to explain human decision-making, the ability to process multiple alternatives and to follow through on a plan of action. It studies how economic behavior can shape our understanding of the ...

.Sauter, Wolf N. (2010)
"Essays on Natural Experiments in Behavioral Finance and Trade"
Doctoral dissertation, Ludwig-Maximilians University, München. In this type of experiments, treatment is assigned randomly to a group of individuals in order to compare their economic actions and behavior to an untreated control group within the artificial laboratory environment. The ability to control the variables in the experiment provides for more accurate assessment of

causality Causality (also referred to as causation, or cause and effect) is influence by which one event, process, state, or object (''a'' ''cause'') contributes to the production of another event, process, state, or object (an ''effect'') where the cau ...

Controlled field studies or randomized field experiments

Controlled field experiments also randomize treatments but do so in real world applications. Average effects on people's behavior can then be consistently estimated by comparing behavior before and after the allocation.

Natural experiments

natural experiment A natural experiment is an empirical study in which individuals (or clusters of individuals) are exposed to the experimental and control conditions that are determined by nature or by other factors outside the control of the investigators. The pro ...

happens when some feature of the real world is randomly changed which allows using the exogenous variation due to this change to study causal effects of an otherwise endogenous explanatory variable. Natural experiments are popular in economic and finance research since they offer intuitive interpretation of the underlying identifying assumptions and enable a broader audience to check their consistency, this compared to purely statistical identification.

Main findings

Experimental methods in finance offer complementary methodologies that have allowed for the observation and manipulation of underlying determinants of prices, such as fundamental values or insider information. Experimental studies complement empirical work, particularly in the area of theory testing and development. Exploiting this experimental methodology has revealed some important findings over the past years. These findings could not have been reached by traditional field data analysis alone and are therefore experimental finance’s main contributions to the field of finance: * Security markets can aggregate and disseminate information (there are efficient markets), but this process is less effective as the information becomes less widely held and the number of information components that must be aggregated increases. * But this is not always the case (some of them are inefficient). * When

information dissemination Privacy (, ) is the ability of an individual or group to seclude themselves or information about themselves, and thereby express themselves selectively. The domain of privacy partially overlaps with security, which can include the concepts of a ...

occurs, it is rarely perfect or instantaneous. Learning takes time. * More information is not always better from the point of view of the individual trader. Only those insiders who are much better informed than others can outperform other traders. * Markets for longer-lived assets have a strong tendency to generate price bubbles and crashes, prolonged deviations from fundamental values. * Emotions of traders play a role in generating bubbles in experimental asset markets. * Asset mispricing has been largely associated with trader overconfidence. * Prices as well as bids, offers, timing, etc., convey information. There are many channels for information flow. * Well-functioning

derivative market The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for exchange-traded derivatives and ...

s can help to improve

primary market :''"Primary market" may also refer to a market in art valuation.'' The primary market is the part of the capital market that deals with the issuance and sale of securities to purchasers directly by the issuer, with the issuer being paid the proce ...

s’ efficiency. *

Statistical efficiency In statistics, efficiency is a measure of quality of an estimator, of an experimental design, or of a hypothesis testing procedure. Essentially, a more efficient estimator, needs fewer input data or observations than a less efficient one to achie ...

or inability to make money using past data does not mean informational efficiency. Not being able to earn abnormal returns from the market does not mean that the price is right.

References

External links

Society for Experimental Finance (SEF)
{{Finance Behavioral finance Experimental economics