Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/110607
Authors: 
Baghestanian, Sascha
Gortner, Paul
Massenot, Baptiste
Year of Publication: 
2015
Series/Report no.: 
SAFE Working Paper Series 108
Abstract: 
In an experimental setting in which investors can entrust their money to traders, we investigate how compensation schemes affect liquidity provision and asset prices. Investors face a trade-off between risk and return. At the benefit of a potentially higher return, they can entrust their money to a trader. However this investment is risky, as the trader might not be trustworthy. Alternatively, they can opt for a safe but low return. We study how subjects solve this trade-off when traders are either liable for losses or not, and when their bonuses are either capped or not. Limited liability introduces a conflict of interest because it makes traders value the asset more than investors. To limit losses, investors should thus restrict liquidity provision to force traders to trade at a lower price. By contrast, bonus caps make traders value the asset less than investors. This should encourage liquidity provision and decrease prices. In contrast to these predictions, we find that under limited liability investors contribute to asset price bubbles by increasing liquidity provision and that caps fail to tame bubbles. Overall, giving investors skin in the game fosters financial stability.
Subjects: 
compensation
liquidity
experimental asset markets
bubbles
JEL: 
C90
C91
D03
G02
G12
Persistent Identifier of the first edition: 
Document Type: 
Working Paper

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