Experimental finance is a field of research that uses laboratory and field experiments, along with other forms of empirical testing, to study financial markets and behavior. It strives to create new models and theories that explain how financial markets function and how decisions are made regarding investments.
Financial market researchers often conduct experiments to test policy changes in real-world scenarios. Furthermore, they use experiments to investigate how different types of information and transparency influence trading behavior and market outcomes.
William Smith’s initial experiments revealed that market equilibrium could exist even in markets with only a few sellers and buyers. This discovery came as a shock; textbooks had always taught that in order for markets to reach competitive equilibrium, an infinite number of sellers and buyers was necessary.
Loren Langan and Anne Villamil have employed experiments to uncover surprising insights about markets. For instance, when there is a significant price disparity between two products, sellers tend to withhold some units from the market – leading prices to drop even lower than what would otherwise be charged in that situation.
Research in experimental economics is also focused on understanding how different market microstructures influence trading behavior and outcomes. This includes studying trading rules, market structure, as well as investor psychology.
Experiments are an efficient way to evaluate the efficiency of financial instruments and markets, such as futures contracts, options contracts, and security markets. They can help identify potential risks and rewards associated with new securities while also showing how a particular event affects prices.
Furthermore, these studies can uncover important behavioral patterns that are hard to measure with other methods. For instance, investors may exhibit high or low risk aversion when making a decision regarding the size of their portfolio.
This information can assist investors in making better decisions and forecast the likelihood that a given stock or asset will reach its expected value. Furthermore, researchers may use it to enhance their forecasting models.
Experimental economics is also useful for studying the impacts of government policies on financial markets. For instance, experimented economics can be employed to test whether government-imposed restrictions on credit are beneficial or detrimental.
Experimental finance has seen numerous encouraging trends over the last several years. There has been an uptick in articles published in experimental finance journals, as well as more interest in conducting field experiments and studies. Furthermore, researchers are now expanding their research agendas to encompass rare and extreme events.