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The authors consider whether the emotional states of happiness and fear causally affect test performance using a new experiment. The paper aims to discuss this issue.

Happiness and fear are induced with 360-degree videos shown in virtual reality before participants take a test consisting of mathematics scholastic aptitude tests (SAT) questions.

The results show that scores improve by 0.48 standard deviations under the happiness condition, and the effect is particularly large for women (0.75 s.d.). Inducing fear has no effect on test scores.

This is one of the first studies to employ virtual reality for emotion induction. It establishes that test scores can be improved by inducing an emotional state of happiness shortly before the test.

The purpose of this paper is to consider whether asymmetric information about correlations between assets can induce financial contagion. Contagion, unjustified by fundamentals, would arise if participants react in one market to uninformative trades in the other market that actually convey no relevant information. The authors also consider whether the market accurately disseminates insider information about fundamental value correlations when such information is indeed present.

The authors employ experimental asset markets to answer the research questions. The experimental markets allow participants to simultaneously trade two assets for multiple rounds. In each round, a shock occurs, which either have an idiosyncratic effect on the shocked asset, or a systematic effect on both assets. Half of the time, there exist insiders who know the true nature of the shock and how it affects the value of the other asset. The other half of the time, no agent knows whether there is a correlation between the assets. In such cases, there is the potential for the appearance of information mirages. Uninformed traders, in either condition, do not know whether or not there exist insiders, but can try to infer this from the market activity they observe.

The results of the experiment show that when inside information about the nature of the correlation between assets does exist, it is readily disseminated in the form of market prices. However, when there is no private information (PI), mirages are common, demonstrating that financial contagion can arise in the absence of any fundamental relationship between assets. An analysis of individual behavior suggests that some unprofitable decisions appear to be related to an aversion to complex distributions of lottery payoffs.

The study focusses on one of the triggers of unjustified financial contagion, namely, asymmetric information. The authors have studied financial contagion in a controlled experimental setting where the authors can carefully control information, and specify the fundamental interdependence between assets traded in different markets.

The purpose of this paper is to introduce the upcoming symposium on experimental macroeconomics in the November issue.

Experimental, survey of articles in the symposium.

The paper describes how experiments can be used in macroeconomics.

The paper discusses the rationale for using behavioral experiments in macroeconomics, and summarizes the papers in the symposium.

The purpose of this paper is to explore the ability of monetary policy to generate real effects in laboratory general equilibrium production economies.

To understand why monetary policy is not consistently effective at stabilizing economic activity, the author vary the types of agents interacting in the economy and consider treatments where subjects are playing the role of households (firms) in an economy where automated firms (households) are programmed to behave rationally.

While the majority of participants’ expectations respond to monetary policy in the direction intended, subjects do form expectations adaptively, relying heavily on past variables and forecasts in forming two-steps-ahead forecasts. Moreover, in the presence of counterparts that are boundedly rational, forecast accuracy worsens significantly. When interacting with automated households, updating firms’ prices respond modestly to monetary policy and significantly to anticipated marginal costs and future prices. The greatest deviations in behavior from theoretical predictions arise from human households (HH). Households persistent oversupply of labor and under-consumption is attributed to precautionary saving and debt aversion. The results provide evidence that the effects of monetary policy on decision making hinge on the distribution of indebtedness of households.

The author present causal evidence of the effects of potential bounded rationality on agents’ consumption and labor decisions.

This paper aims to study how the trajectory of fundamental values affects price discovery in an experimental asset market.

An experiment is conducted with two treatments, in which the time path of fundamentals differs between treatments. In the peak treatment, fundamentals first rise and then fall, while in the valley treatment fundamentals first fall and then recover. The experiment allows market prices to be compared to fundamental values.

Both peak and valley treatments experience bubbles when traders are inexperienced. However, price discovery is more rapid and complete in the peak than in the valley treatment. In the peak treatment, prices track the value, the direction of the trend, and changes in trend, more closely than in the valley treatment.

This paper documents the first experimental results regarding pricing behavior in markets with non‐monotonic fundamentals. It creates an environment (the valley treatment) in which convergence to close to fundamentals does not occur even with repetition of the market under identical conditions. The results demonstrate that the likelihood that an asset market tracks fundamentals depends on the time path of fundamentals.

How can laboratory experiments help us understand banking crises, including the usefulness of various policy responses? After giving a concise introduction to the field of experimental economics more generally, the author attempts to provide answers. The paper aims to discuss this issue.

The author discusses methodology and surveys relevant work.

History is often too complicated to be meaningfully revamped or modified in the lab, for purposes of insight-by-analogy. But as people argue about how to understand financial history, they bring ideas to the table. It is possible and useful to test the empirical relevance of these ideas in lab experiments.

The paper pioneers broad discussion of how lab experiments may shed light on banking crises.

In games with strategic complementarities, public information about the state of the world has a larger impact on equilibrium actions than private information of the same precision, because the former is more informative about the likely behavior of others. This may lead to welfare-reducing “overreactions” to public signals as shown by Morris and Shin (2002). Recent experiments on games with strategic complementarities show that subjects attach a lower weight to public signals than theoretically predicted. The purpose of this paper is to reconsider the welfare effects of public signals accounting for the weights observed in experiments.

Aggregate behavior observed in experiments on games with strategic complementarities can be explained by a cognitive hierarchy model where subjects employ limited levels of reasoning. They respond in a rational way to the non-strategic part of a game and they account for other players responding rationally, but they neglect that other players also account for others’ rationality. This paper analyzes the welfare effects of public information under such limited levels of reasoning.

In the model by Morris and Shin (2002) public information is always welfare improving if strategies are derived from such low reasoning levels. The optimal degree of publicity is decreasing in the levels of reasoning. For the observed average level of reasoning, full transparency is optimal, if public information is more precise than private information. If the policy maker has instruments that are perfect substitutes to private actions, the government should secretly respond to its information without disclosing or signaling it to the private sector independent of the degree of private agents’ rationality.

This paper takes experimental evidence back to theory and shows that the main result obtained by the theory under rational behavior breaks down if theory accounts for the bounded rationality observed in experiments.

In this paper, we study the effect of induced positive and negative moods on traders' willingness to trade (pay and accept) in experimental asset markets.

We conduct experimental asset markets where subjects undergo a mood induction procedure prior to trade. After the subjects are induced with either negative or positive affect, they can trade an experimental asset with a known stream of dividends for a known number of periods.

We first show that both positive and negative affects are associated with larger positive deviations from fundamental values. We also show that when subjects are induced with positive mood, they bid higher prices but for fewer units of the stock. On the supply side, positive affect is associated with higher prices and quantities, and consequently in higher willingness to offer. Finally, we use our experimental data to test existing theories on mood effect. We find that negative affect is related to momentum trading, while positive affect is associated with information processing.

To our knowledge, this is the first work that studies the effect of mood on traders' behavior, rather than market outcomes.

This study aims to draw on a less explored predictor – the average correlation of pairwise returns on industry portfolios – to predict stock market returns (SMRs) in the USA.

This study uses the average correlation approach of Pollet and Wilson (2010) and predicts the SMRs in the USA. The model is estimated using monthly data for a long time horizon, from July 1963 to December 2018, for the portfolios comprising 48 Fama-French industries. The model is extended to examine the effects of a longer lag structure of one-month to four-month lags and to control for the effects of a number of variables – average variance (AV), cyclically adjusted price-to-earnings ratio (CAPE), term spread (TS), default spread (DS), risk-free rate returns (R_f) and lagged excess market returns (R_s).

The study finds that the two-month lagged average correlation of returns on individual industry portfolios, used individually and collectively with financial predictors and economic factors, predicts excess returns on the stock market in an effective manner.

The methodology and results are of interest to academics as they could further explore the use of average correlation to improve the predictive powers of their models.

Market practitioners could include the average correlation in their asset pricing models to improve the predictions for the future trend in stock market returns. Investors could consider including average correlation in their forecasting models, along with the traditional financial ratios and economic indicators. They could adjust their expected returns to a lower level when the average correlation increases during a recession.

The finding that recession periods have effects on the SMRs would be useful for the policymakers. The understanding of the co-movement of returns on industry portfolios during a recession would be useful for the formulation of policies aimed at ensuring the stability of the financial markets.

The study contributes to the literature on three counts. First, the study uses industry portfolio returns – as compared to individual stock returns used in Pollet and Wilson (2010) – in constructing average correlation. When stock market becomes more volatile on returns, the individual stocks are more diverse on their performance; the comovement between individual stock returns might be dominated by the idiosyncratic component, which may not have any implications for future SMRs. Using the industry portfolio returns can potentially reduce such an effect by a large extent, and thus, can provide more reliable estimates. Second, the effects of business cycles could be better identified in a long sample period and through several sub-sample tests. This study uses a data set, which spans the period from July 1963 to December 2018. This long sample period covers multiple phases of business cycles. The daily data are used to compute the monthly and equally-weighted average correlation of returns on 48 Fama-French industry portfolios. Third, previous studies have often ignored the use of investors’ sentiments in their prediction models, while investors’ irrational decisions could have an important impact on expected returns (Huang et al., 2015). This study extends the analysis and incorporates investors’ sentiments in the model.

The purpose of this paper, and a companion paper (Duxbury, 2015), is to review the insights provided by experimental studies examining financial decisions and market behavior.

Focus is directed on those studies examining explicitly, or with direct implications for, the most robustly identified phenomena or stylized facts observed in behavioral finance. The themes for this first paper are theory and financial markets.

Experiments complement the findings from empirical studies in behavioral finance by avoiding some of the limitations or assumptions implicit in such studies.

The authors synthesize the valuable contribution made by experimental studies in extending the knowledge of the functioning of financial markets and the financial behavior of individuals.