Bank of Lithuania
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2016-08-02

No 30. Matthias Weber, John Duffy, Arthur Schram. An experimental study of bond market pricing

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The experimental literature on asset markets has provided many useful insights on the efficiency of market mechanisms. It is unclear whether these results carry over to bonds markets, however. An important feature of bond markets is the relationship between initial public offering (IPO) prices and the probability that the bond issuer will default. First, this probability affects the value of the bond and, therefore, the bond prices. Second, prices paid for the bonds in the IPO determine the bond issuer’s financing costs and, therefore, affect the probability that the bond issuer defaults. We develop a flexible bond market model that accounts for this two-way interaction and that is easily implemented in the laboratory. We examine how subjects price bonds in this setting and find that subjects learn to price bonds rather well after only a few repetitions (both during the IPO and while trading in the secondary market afterward). Bubbles in bond prices are only observed among inexperienced traders. The overall high degree of market efficiency that we find occurs in environments with both increasing and decreasing (equilibrium) fundamental values for bonds.

JEL Codes: C92, C90, D47, G12.

The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

Matthias Weber, John Duffy, Arthur Schram, bond markets, experimental finance, experimental markets, learning, Asset pricing